Picking the “right” corporate form when starting a business can be a daunting and confusing task. Except for a few legally-mandated forms for certain types of business, you’ll likely have several corporate forms to choose from–all having pros & cons. There may not be a wrong answer . . . but it’s always more efficient and economical to start with the best form for your needs and vision (rebranding is expensive!).
To make it more confusing, depending upon which business attorney or general practice lawyer you ask, you may get opposing viewpoints. For example, I recently followed a lively discussion thread on a legal listserve (yes, we still use listserves), debating whether a limited liability company (LLC) structure or corporation (Corp., Inc. or C-Corp.) was the best corporate form to use when you know you want to offer employee’s ownership in the company, a common need for technology companies. Another lengthy thread discussed the merits of member-managed versus manager-managed LLCs. I don’t mention these to display (or “out”) my inner law geek (yes, I read listserves for fun), I mention it because you have options and it’s a good idea to understand those options before you choose.
Following is a brief rundown on the most popular corporate form used in Texas, the LLC.
Limited Liability Company (LLC): The LLC structure is by far the most popular in Texas (and across the nation), in 2014, 80% of new businesses in Texas were LLCs.
PROS: LLC’s are popular because they provide personal liability protection, financial and management flexibility, and minimal corporate formality overhead. Liability of the members of the LLC (owners of LLCs are referred to as “members”) is typically limited to their investment in the LLC. And, unlike the S-Corp form, there is no limit to the number of members an LLC can have and foreign members are not prohibited. Further, although single-member LLCs (i.e. sole owner) are taxed as sole-proprietorships with all income “passing through” and reported on the member’s individual tax return, multi-member LLCs have the option of being taxed as a S-Corp or C-Corp. Additionally, LLCs generally allow for special allocation of profits (splitting profits and losses differently than ownership percentages). But you have to have the right documents in place to take advantage of these benefits (see the section on common formation pitfalls, below).
CONS: Members’ share of profits represent taxable income, regardless of distribution; thus, you’re taxed whether you have cash in hand or not. LLCs may not be the best form if you are seeking venture capital, want to offer employee-ownership options, or intend to eventually “go public.” And although in Texas, LLCs are available to “professionals” (i.e. Doctors, Lawyers, etc.) under the PLLC (Professional Limited Liability Company) form, some states do not allow professionals to form an LLC. The use of “series LLCs” (in a nutshell individual LLCs nested under a single LLC registration) has been discussed a great deal among lawyers and business commentators. The theory behind the structure was to allow LLCs to more flexibly partition liability associated with certain assets among a differing mix of members without the need to register separate numerous distinct entities. The form is most commonly deployed in real-estate investment companies. But, the form is relatively new, is not recognized in all states, and the ultimate protection it offers has not yet been defined fully by the courts (so make sure you’re fully briefed on this aspect before choosing a series LLC).
COMMON PITFALLS: Common problems with formation I’ve encountred include
- Failure to create and correctly adopt all of the documents necessary to LLC formation. Forming a LLC in Texas appears relatively easy, you simply file a two-page form with the Secretary of State and pay a filing fee, right? Many formation efforts end with filing the two-page form with the state. Unfortunately, to take full advantage of the LLC form, there is, or should be, more to it than that. First and foremost, its a good idea to make sure you understand the selections you make on the form itself. Notably, the impact of whether you select “member managed” or “manager managed” has both tax and operational implications. And, if you don’t draft and adopt a company agreement, by default you are operating under the Texas Business and Organizations Code, the provisions of which may not be favorable to you (e.g. the profit and cost sharing provisions).Without proper authorization of the formation, adoption of the company agreement, and authorization of the foundational steps (e.g. opening a bank account), it may be a lot harder to show that you or the LLC was operating within proper authority when challenged in a lawsuit.
- Failure to properly maintain corporate formalities, registration and paperwork. Once formed many, many companies fail to maintain the proper corporate formalities. Members forget to hold annual meetings, document and properly adopt meeting minutes, operate out of the bounds of the company agreement (e.g. don’t take votes on items requiring a vote), forget to reelect officers when necessary, or fail to maintain accurate capital accounts. Additionally, I’ve had more than one business seek counsel to address a default judgment caused by the company’s failure to keep its registered agent information updated with the Secretary of State. Another common problem I’ve dealt with is reinstating entities for failure to file the Texas Franchise Tax form. The Texas Franchise Tax form is due May 15 (one month after your federal taxes are due), and, unless you have an express excuse not to do so, you must file the form regardless of whether you owe any money. If you fail to file the form, the Texas Comptroller will send you a delinquency notice. If you ignore that, the Comptroller will notify the Secretary of State and the Secretary of State will issue a tax-forfeiture for your business. The reinstatement process is, in itself, not difficult, but the reason tax-forfeiture is a BIG problem is that any liability protection offered by the entity ends at the time of forfeiture (and is reinstated when the entity is reinstated). Thus, there is a potential gap in liability protection for the members and any action taken on the entity’s behalf while the entity is forfeit subjects the actor and/or the entity’s member(s) to personal liability.
- Failure to correctly name the entity in legal documents. Many entities forget to use their proper legal name when entering into contracts or to properly indicate that the signatory is signing on “behalf of” or “for” the entity. Oversights that could open the individual signing the document up to personal liability. Agency is not presumed in Texas, it must be proven. Thus, it is critical that you (the person signing the document) make it clear that you are acting on behalf of a legally-formed and valid entity. Using the correct legal name of the entity (e.g. “XYZ, LLC d/b/a Toodle’s Bake Shop” and not “XYZ” (without the LLC) or “Toodle’s Bake Shop”) and making sure the signature line includes the phrases “On Behalf of XYZ, LLC” or “For XYZ, LLC” and indicating the authority under which you sign (i.e. adding “By its President” or other appropriate title), will go a long way to keeping you, as signatory away from inadvertently assuming personal liability.
MORE INFORMATION ON PICKING AN ENTITY: For general information on the pros & cons of LLCs, check out Entrepreneur’s LLC Basics post. For information specific to Texas, check out the Texas Secretary of State’s website (If you’re not in Texas, check out your state’s Secretary of State website for your specific laws, regulations, procedures and FAQs).
FOR MORE INFORMATION ON WHO CAN HELP YOU FORM YOUR NEW BUSINESS, see my related blog post and PDF on how to select the right attorney for your business.
Constance Hall, an experienced legal, marketing and client relationship professional, is licensed to practice law in Texas. For more information, if you have questions, or to contact Connie, email her at firstname.lastname@example.org.