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Business Formation and Restructuring

Starting and Growing a Business Can Make Your Dreams a Reality

Forming a business can be the first step in making a dream a reality. However, there are many steps in a proper business formation. Business formation begins with selecting a business structure. And, there are many factors that should be considered when opting for one structure over another. However, at a minimum, consideration should be given to the owner's personal liability for actions taken on behalf of the business, to the taxes the business and the owner/s pay on the business' profits, and to the steps needed to form the business.

 

The simplest form of business is the sole proprietorship.  A sole proprietorship, as defined by Black’s Law Dictionary, is "[a] business in which one person owns all the assets, owes all the liabilities, and operates in his or her personal capacity".[1] In a sole proprietorship, the owner is personally liable of any harm or damages that result from the business's activities. However, as the business generates profit, the owner is only taxed on that profit at their personal level, not at the business level and again at their level. In addition, there are no state filing requirements or formation documents needed to establish a sole proprietorship. 

 

The next most basic form of business structure is a general partnership. A general partnership occurs when two or more people engage in an activity for profit. All of the partners are personally liable for any harm or damages that occur from the business activities of the partnership, regardless of whether that partner participated in the underlying activity. As with the sole proprietorship the partners are only taxed at their personal level and not at the business level. And, there are no state filing requirements or formation documents needed to establish a general partnership. However, it is strongly recommended that the partners create a partnership agreement to govern their relationship to the business. A partnership agreement should address the various partners' roles in the business, the distribution of profits and control of the partnership assets, voting rights, adding and removing partners, and how to dissolve the partnership, if needed. Partnership agreements are complex documents that should be drafted by an attorney and tailored to the business. There are forms of limited partnerships whereby some of the partners have no active role in the operations of the business, and, thus, are not personally liable for the business' actions. In a limited partnership, only the general partner/s are personally liable for the actions taken on behalf of the business. However, limited partnerships must register with the Texas Secretary of State to limit the liability of the limited partners. Limited partnerships can be used for estate planning purposes, enabling the general partner to control their assets while gifting, over time, their interest in the partnership to their heirs without triggering gift or estate taxes. Limited partnerships, like general partnerships, are complex and should be created by an attorney and tailored to the business or use.

 

Wishing to avoided personal liability for the actions of the business, some people opt to create a corporation. Corporations shield the owners of the corporation from personal liability for actions taken on behalf of the corporation that they did not personally make. However, corporations are legal entities separate from their owners. As such, corporations are taxed on the profits they make. And, once that profit is distributed to the owners, the owners pay that again at their personal level. In addition, Texas law requires that corporations file a Certificate of Formation with the Secretary of State. The creation of a corporation also requires the adoption of bylaws, which like a partnership agreement, set the terms of governing the business. Shares need to be issued and kept in a registry. And, minutes of director and shareholder meetings need to be maintained. Corporations, like partnerships, are complex entities that should be created by an attorney and tailored to the business. A common practice among owners of smaller corporations is opt to make the corporation an S-corp to avoid the double-taxation affect. S-corp elections derive out of federal taxation regulations, not state laws. And, making the S-corp election impacts the size of the corporation and impacts decisions to sell corporate assets. Opting to make this election should only be done under the advice of an accountant.

 

The most common business structure is the Limited Liability Company--the LLC. LLCs can limit the liability of the owners--called "members". And, they enable the members to only be taxed at their personal level, like a partnership. A certificate of formation must be filed with the Texas Secretary of State to create an LLC. In addition, LLCs are governed by formation documents similar to those used to form corporations (e.g. bylaws, unit certificates, and minutes). LLCs, like partnerships and corporations, are complex entities and should be created by an attorney and tailored to the business.

 

Non-profits are another common business entity. Non-profits are typically formed as corporations, although they can take other forms (e.g. trusts). To create a non-profit, the underlying business is formed. And, then, an application is made to the IRS for tax-exempt status. The IRS will grant tax-exemption for many different reasons. However, most commonly, non-profits are granted tax-exemption under Internal Revenue Code Section 501(c)(3) for the purposes of "charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, and preventing cruelty to children or animals".[2] Once the IRS grants tax-exempt status on the business, the operators of the non-profit must file for tax exemption with the Texas Comptroller. Creating a non-profit has all of the complexity of forming the underlying business with the added requirements of obtaining federal and state tax-exempt status. Care should be taken in the establishment of a non-profit. And, the creation of a non-profit should be done with the help of an attorney.

 

Many business owners create their business and never review their formation documents. Very often the business will grow in ways not contemplated in the original documents. As such, periodic review of the formation documents is advisable. A restructuring of the business may be necessary to enable the business to continue to grow or to get the business ready for sale.

To be attractive to a potential buyer, a business should be well-organized and easy to understand. The business formation documents need to allow for a sale of the business. And, the assets should be owned by the appropriate business or sub-entity and comingled with personal assets. Correctly ordering the assets of a business make involve retitling equipment or deeding property. As with other facets of operating a business, restructuring a business is a complex and should be undertaken with the assistance of an attorney.

[1] Black’s Law Dictionary (11th ed. 2019), sole proprietorship, 1st definition.

[2] irs.gov/charities-non-profits/chariable-organizations/exempt-purposes-internal-revenue-code-section-501c3.

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