Corporate Structure Series, Post #3: Entity Selection with guest, AndrewsCPA

We’re sure you are wondering, “Another post on entity choice? Really?” Yes, it is that important. We have the privilege of co-writing a blog post today! Our names are Keith Maynard and Mary Margaret Croft.  Keith is a CPA at Andrews CPA, PLLC here in Waco.  He specializes in providing outsourced accounting solutions to growth-minded businesses.  Mary Margaret is an attorney with Carpenter & Croft, PLLC here in Waco.  She practices in the areas of real estate, corporate entities and formation, contracts, and estate planning. We could write an entire volume on this topic; however, we are going to focus on a few common types of entities for this post. As always, these choices are very complex and you should always consult a legal and tax advisor before deciding.

Corporation:

Mary Margaret: I do not recommend corporations often. Although it provides protection from liability like an LLC, a corporation is a lot more work to maintain. The designations for “C Corporation” or “S Corporation” primarily refer to the federal tax treatment election a corporation has made – they do not refer to different legal entity types. A corporation, whether a C Corp or an S Corp, is an incorporated entity filed in Texas with the Texas Secretary of State (SOS), or the appropriate state entity in other states. They are governed by a board of directors, and the assets are held or “owned” by the corporation’s shareholders. Unlike an LLC’s owners, a corporation’s shareholders typically have a passive role, and are not involved in the day-to-day governance of the Corporation. Note that in smaller corporations a shareholder may wear multiple hats and also act as a director and/or an officer.  Corporations require a lot of upkeep as they must have bylaws (the governing document), hold regular meetings of the board of directors, record meeting minutes, maintain records of all accounts, issue shares, and elect officers. Unless you plan to incorporate a publicly-traded conglomerate, a bank, or an insurance company, a corporation is probably not the best fit.

Keith: There are two tax elections that can be made for a corporation: “Close Corporations” (also known as “C Corps”) and “Subchapter S Corporations” (also known as “S Corps”).  C Corps are generally not favorable for tax purposes.  Income is first taxed at the entity level, and then is taxed again as dividends to the shareholders. C Corps would be a fit for companies that want to access capital markets, or for companies that need a clear exit strategy. This entity is subject to the Texas Franchise Tax, like all other entities that provide limited liability protection. Out of the corporate options, S Corps have become much more popular over the last several years.  One of the biggest benefits is flow-through taxation.  The income is passed through to the shareholders and taxed at the individual level.  There are also some planning options when it comes to minimizing self-employment tax. Downsides to an S Corp are the shareholder limitations (less than 100, and only individuals who are US citizens or residents, certain trusts, and estates can be shareholders), and they can only have one class of stock.  Any distributions to shareholders must be made pro rata by stock ownership, which prohibits any type of unique income or loss allocations that are provided for in other entity types. Lastly, it is much more difficult to contribute property into and distribute property out of an S Corp without gain recognition. This entity is also subject to the Texas Franchise Tax.

Limited Liability Company (LLC):

Mary Margaret: LLCs are fantastic because of the liability protection and the flexibility they provide, both from a tax standpoint and from a legal standpoint. The entity must be filed with the SOS to begin. An LLC’s governance is provided in its Company Agreement which can be structured however the members see fit.  LLCs are typically managed by their members; however, the Company Agreement can specify that the LLC is to be managed by managers, and the members can be passive investors instead. Unlike a corporation with an S Corp election, there are no restrictions on the number of members the LLC can have, or the type of entities that can be members. Also, in contrast to a corporation, an LLC can also make distributions to its members without regard to the percentages of initial capital contributions the members made.

Keith: LLCs have quickly become one of our favorite entity selections. LLCs provide flow-through taxation to its members. LLCs can also allocate income and loss as agreed to in the company agreement.  This is especially helpful with complex agreements with multiple different types of members. It is also much easier to contribute property into and distribute property out of an LLC and the basis follows the property. A downside is that all income for active members is subject to self-employment tax. This entity is also subject to the Texas Franchise Tax.

General Partnership:

Mary Margaret: A general partnership is the only entity on this list that does not have to be filed or registered with the SOS. The benefit to a general partnership is that it can be formed instantly with little to no cost (no state filing fees!).  While it is best to have a partnership agreement delineating your partnership interests and roles, it is not required. One large downside to a general partnership is that the owners have no protection from liability. The partners are personally liable for anything the partnership does wrong, its debts and its liabilities. This risk component can be mitigated by insurance if need be, but most people prefer protection from personal liability and choose to use a different entity structure.

Keith: General Partnerships are very similar to LLCs from a taxation standpoint. The major difference is that a general partnership whose partners are all natural persons, is not subject to the Texas Franchise Tax. If a partner is another entity, the partnership may not owe Texas Franchise Tax if its receipts are greater than 90% from passive sources (dividends, interest, distribute shares of partnership income, net capital gains, royalties, etc.) Please note that rents do not count as passive income!

Limited Partnership:

Mary Margaret: Limited partnerships are also filed with the SOS and provide protection from personal liability. The LP’s governing document is called a Partnership Agreement. Limited partnerships are managed by the General Partner, while the limited partners act as passive investors in the entity. LPs can have several classes of limited partners or general partners, each class having its own allocation of profits and losses, voting rights, and return of capital contributions. An LP can be a great vehicle for certain specific purposes, such as real estate syndications, family estate planning, and oil and gas transactions. However, an LP is generally difficult to manage (much more work than an LLC), and much more costly. For example, in Texas the filing fee with SOS is more than double that of an LLC.

Keith: Limited Partnerships are also very similar to LLCs from a taxation standpoint. This entity is subject to the Texas Franchise Tax, unless it is considered passive under the aforementioned rules.

There are other types of entities you may want to consider that we have not discussed here. Proper tax and legal planning at the outset can make for a smooth start to your new business. Give us a call if you have questions and want to discuss further: Carpenter & Croft, PLLC (254) 300-7909 and AndrewsCPA, PLLC (877) 686-6080.  Please note that while we love to work together, Carpenter & Croft, PLLC and AndrewsCPA, PLLC are not affiliated entities and do not share fees.