by Ron Holmes
Many of our readers are real estate developers, investors, and leasing/management companies or folks starting or expanding a myriad of businesses. All are faced with a fundamental question: should I conduct business in my name or should I form a general partnership, limited partnership, limited liability company, S-Corp or C-Corp? This article addresses that fundamental question.
Sole Proprietorship. The American Dream is built upon entrepreneurship: the man or woman who breaks from the pack and starts his or her own business, thereby creating their own freedom and enhancing the economy by building a platform that employs others. Some of these dreamers/doers start the business using their own names or a d/b/a without creating a separate legal entity. Not a good start. Doing business in your own name insures you will get sued personally for business debts, the business lease and anyone injured at your business or by your business.
General Partnership. A general partnership is nothing more than 2 or more people joined together for a common enterprise. If you join together as individuals, each general partner runs the same third-party liability risk as a sole proprietor. This is not a good choice. A general partnership may be formed by a verbal agreement or a written agreement. Of course, we recommend a written agreement.
Limited Partnership. This entity can limit your exposure to third-party liability. There are two types of partners; the general partner and the limited partner(s). The limited partners are protected from the liabilities of the limited partnership and third-party liability as a matter of law. Not so for the general partner: You never want to be the general partner in a limited partnership in your individual name. You should create a LLC or Sub-S Corporation to serve as the general partner.
In simple, small transactions, a limited partnership can be expensive to form. First, you need to form a LLC or Sub-S to serve as the general partner, which entails Secretary of State filing fees ($300 for an LLC or Sub-S). Second, the Secretary of State filing fee is $750 for a limited partnership. So, you have to pay $1,050 in filing fees plus legal fees to draft both the Company Agreement for the LLC and the Limited Partnership Agreement for the limited partnership.
Even so, we recommend the limited partnership structure as a means of avoiding the Texas Franchise Tax on a disposition that results in significant capital gain. Those are details beyond the scope of this article.
This structure is a good vehicle for raising equity as there can be unlimited numbers of limited partners (natural persons or legal entities), different classes of limited partners, special allocations of income and losses and of cash flow and capital proceeds.
Sub-S Corporation. No longer in vogue, this entity is the forerunner of the LLC. There are advantages and disadvantages to the S Corp. It is a flow-through entity (no tax at the corporate level). Because it is a corporation, shareholders may also be employees and, therefore, receive W-2 wages. Like an LLC, C-Corp or Limited Partnership, the S-Corp shareholders are protected from creditors. Unlike a Limited Partnership or an LLC, more than fifty percent (50%) of the stock can be transferred in one calendar year without triggering negative tax ramifications. But, there are also disadvantages. With rare exceptions, the stock must be owned by human beings, which prevents the layering of entities that we typically see in large transactions. An S-Corp can have only one class of stock (although it can be voting and non-voting). Thus, it is difficult to have special allocations of cash flow or capital proceeds. The same is true with respect to the allocation of losses and income for tax purposes. Even so, the S-Corp is still a good vehicle for personal service businesses.
C-Corporation. This is the traditional corporation and a good entity for wealth accumulation. Unlike an S-Corporation, there may be various classes of stock, the stock may be owned by other entities and there is no limit on the number of shareholders, all of which contribute to the C-Corp’s ability to raise capital from investors. The big down side to a C-Corp is double taxation, that is, the corporation itself is taxed and dividends distributed to shareholders are separately taxed. Think BIG companies when thinking C-Corporations and definitely don’t think real estate as this is not the entity in which to own real estate.
Limited Liability Company. This entity is the darling of entities in 2017. The LLC can be a single member entity, meaning only one (1) person owns it or it is owned by a husband and wife (in either case a “disregarded entity” for tax purposes, provided the married couple uses community funds to create same), which makes drafting the Company Agreement a relatively easy task for a lawyer competent in that area. Of course, the more Members in the LLC, the more difficult the drafting can be. Many of our clients have deeply layered entity structures that entail complex entity drafting issues.
The owners of an LLC are Members (not partners or shareholders), but often the LLC is managed by Managers, who can appoint Officers (much like a corporation). The controlling document is the Company Agreement, which can be simple or very complex, addressing such issues as voting rights, different classes of Members, special tax and cash allocations, transferability, buy-sales, mandatory capital contributions and remedies for failure to perform.
As with limited partners or shareholders, the Members are protected from third party liability for the LLC’s activities.
This entity is a good choice for everything from a small business to a large business, a simple deal to a complex deal, except we do suggest the limited partnership structure for transactions that may result in significant capital gain.
Conclusion. Which entity is appropriate for your business is an important decision, as each has advantages and disadvantages. The foregoing are ABC’s. Before you decide, you need to know the A to Z. You are strongly encouraged to seek the advice of legal counsel (as opposed to the various online dispensers of legal advice) to select the entity that is appropriate to you. The lawyers in our firm have formed thousands of entities and are regularly called upon to assist clients with the structuring and layering of entities in complex transactions, as well as simple business start-ups. One of our lawyers will be happy to assist you.