Business Entity Formation in Texas: Tax and Liability Considerations
If you are thinking about forming your own business in Texas, there are lots of options out there in terms of what form your business should take - an LLC, a corporation, a partnership, and several more. In this post, I’ll share some quick insights into why you may want to choose a particular business form over another.
Most of my clients contemplating this question have two major considerations: liability protection and federal tax treatment. Liability protection means whether the business type shields the owners from personal liability for the business’s debts and obligations. Not all entities provide this protection.
Tax treatment, the second consideration, generally means whether the business is required to file and pay its own taxes or if the profit/loss is reported on the individual owner(s) tax returns. This is an important question because it can significantly lower or raise the owner’s tax burden.
Let’s start with the simplest of the business forms available in Texas: a sole proprietorship. A sole proprietorship is the simplest of business organizations because it isn’t really one. Unless you file paperwork forming a different kind of business organization, any business you start will, by default, be a sole proprietorship. Sole proprietorships are easy and inexpensive to start, and their federal tax situation is very simple: any income from your business will be reported on your own tax return and taxed at individual income tax rates, not corporate tax rates. There are, however, several downsides to this business entity. Most importantly, there is no liability protection for the owner of the business. That means the owner is personally liable for the debts of the business, and creditors of the business can go after his or her personal bank account, car, and other personal property in order to satisfy the business’ debts.
Very similar to the sole proprietorship is the general partnership. Like the sole proprietorship, you can form a general partnership without having to file formation paperwork with the state of Texas. The primary difference between the two entities is that the general partnership has more than one owner, while the sole proprietorship can only have one. The biggest downside of a general partnership is also the same as the sole proprietorship: there is no liability protection for the owners. This means that all of the partners who own the business are personally liable for the business’s debts and obligations, as well as any wrongdoing or negligence of their other partners. From a tax perspective, there is no difference between the general partnership - your share of the profits and losses are reported on your individual tax returns and taxed at those rates.
Next up is the limited partnership. As its name implies, the limited partnership differs from the general partnership in one key way - limited personal liability. A limited partnership requires at least two partners - one general partner, and one limited partner, although there can be more of each type. The general partner in a limited partnership remains personally liable for the debts and obligation of the partnership, as well as the wrongful actions of the other partners. The limited partner, however, is not. Their liability is limited to the amount of capital they have contributed to the company. For example, a limited partner who contributes $5,000 to the business venture could lose his $5,000 investment, but none of his personal assets, even if the business owed much more or one of the other partners did something wrong. Taxes in a general partnership are also passed through to the individual owners in proportion to the share of the business they own.
The limited liability partnership is a business organization type that, in Texas at least, is generally only used by partners in a certain profession (lawyers, doctors, accountants, and engineers) who work together in a partnership by contributing labor, skill, and money to the company. They choose this form because, unlike a general partnership, the limited liability partnership provides protection for individual partners against the negligence of other partners within the organization. That liability is limited, however, because it does not protect the limited partners from the debts and obligations of the partnership itself. There is, therefore, still substantial risk to the personal assets of the partners. Like other partnership entities, taxes are reported on the individual partner’s tax returns; the entity itself generally does not have to file any tax returns.
That wraps up the first part of this post on partnerships and sole proprietorships. Look for part two about the two big hitters, corporations and LLCs, coming soon!