I. GENERAL.

A. Introduction.

In selecting a form of business entity for an oil patch deal in Texas the organizer or initial owners can consider the following five business entity forms:

• Corporation

• General Partnership

• Limited Partnership

• Limited Liability Partnership (“LLP”)

• Limited Liability Company (“LLC”)

The form of business entity most advantageous in a particular situation depends on the business objectives for which the entity is being organized. In most situations, the choice of entity focus will be on how the entity and its owners will be taxed and the extent to which the entity will shield the owners and managers of the business from liabilities arising out of its activities. An increasingly important factor in choosing the form of entity, and its state of domicile, is the extent to which the fiduciary duties and personal liability of the entity’s governing persons may be limited in the entity’s governing documents. The 83rd Texas Legislature, 2013 Regular Session (the “2013 Legislative Session”), which convened on January 11, 2013 and adjourned on May 27, 2013, did not change the forms of business entity from which to choose or the principal entity choice factors for an oil patch deal, but did enhance their flexibility and the desirability of Texas as a place to organize a business.

Until the 1990s, the spectrum of business entity forms available in Texas was not as broad as it is today. In 1991, the Texas Legislature passed the world’s first LLP statute permitting a general partnership to significantly limit the individual liability of its partners for certain acts of other partners by the partnership making a specified filing with the Secretary of State of Texas (the “Secretary of State”) and complying with certain other statutory requirements. The Texas LLP statute was later amended to extend its LLP shield to contracts. Also in 1991, Texas became the fourth state to adopt a statute providing for the creation of an LLC, which limits the personal liability of LLC interest owners for LLC obligations at least as much as the liability of corporate shareholders is limited for corporate obligations. Today, all fifty states and the District of Columbia have adopted LLP and LLC statutes, and the LLC has become the entity of choice for private deals.

The Texas Legislature enacted the Texas Business Organizations Code (the “TBOC”) to codify the Texas statutes relating to business entities referenced above, together with the Texas statutes governing the formation and operation of other for-profit and non profit private sector entities. The TBOC is applicable to entities formed or converting under Texas law after January 1, 2006. Entities in existence on January 1, 2006 could continue to be governed by the Texas source statutes until January 1, 2010, after which time they must conform to the TBOC, although they could elect to be governed by the TBOC prior to that time.

Federal and state taxation of an entity and its owners for entity income is a major factorin the selection of the form of entity for a particular situation. Under the United States (“U.S.”) Internal Revenue Code of 1986, as amended (the “IRC”), and the “Check-the-Box” regulations promulgated by the Internal Revenue Service (“IRS”), an unincorporated business entity may be classified as an “association” taxable as a corporation subject to income taxes at the corporate level ranging from 15% to 35% of taxable net income, absent a valid S corporation status election, which is in addition to any taxation which may be imposed on the owner as a result of distributions from the business entity.7 Alternatively, the entity may be classified as a partnership, a non-taxable “flow-through” entity in which taxation is imposed only at the ownership level. Although a corporation is classified only as a corporation for IRC purposes, an LLC or partnership may elect whether to be classified as a partnership. A single-owner LLC is disregarded as a separate entity for federal income tax purposes unless it elects otherwise. In addition to federal tax laws, an entity and its advisors must comply with federal anti money laundering and terrorist regulations.

Texas does not have a state personal income tax. The Texas Legislature has replaced the Texas franchise tax on corporations and LLCs with a novel business entity tax called the “Margin Tax,” which is imposed on all business entities other than general partnerships wholly owned by individuals and certain “passive entities.” Essentially, the calculation of the Margin Tax is based on a taxable entity’s, or unitary group’s, gross receipts after deductions for either (x) compensation or (y) cost of goods sold, provided that the “tax base” for the Margin Tax may not exceed 70% of the entity’s total revenues. This “tax base” is apportioned to Texas by multiplying the tax base by a fraction of which the numerator is Texas gross receipts and the denominator is aggregate gross receipts. The tax rate applied to the Texas portion of the tax base for 2014 is .975% for all taxpayers, except a narrowly defined group of retail and wholesale businesses that will pay a .4875% rate. For calendar year taxpayers, the Margin Tax is payable annually on May 15 of each year based on entity income for the year ending the preceding December 31.

The enactment of the Margin Tax changed the calculus for entity selections, but not necessarily the result. The LLC became more attractive as it can elect to be taxed as a corporation or partnership for federal income tax purposes, but the uncertainties as to an LLC’s treatment for self-employment purposes continue to restrict its desirability in some situations.