Business owners in the State of Texas face a lot of tough decisions. Perhaps the most significant of these decisions is the choice of entity the business will utilize while conducting its operations. Similar to many other states, the State of Texas offers its business owners and entrepreneurs several options. This Insight provides a summary of the tax and non-tax implications of each potential entity.
It may surprise you to learn that starting a business in Texas sometimes does not require any formal organization paperwork at all. For example, a business owner or entrepreneur may begin conducting business in Texas under his or her own name.[i]
Major advantages of operating as a sole proprietorship include ease of formation and management. A major disadvantage of operating as a sole proprietor is that the sole proprietor is liable for all of the debts and obligations of the business.[ii]
For federal tax purposes, a sole proprietor’s business activities are reported on Schedule C, Profit or Loss from Business. Accordingly, the sole proprietor’s business activities (income and losses) are reported directly on the sole proprietor’s individual income tax return.
Sole proprietors are not subject to Texas franchise tax.[iii] See Tex. Tax Code § 171.0002(b)(1).
Limited Liability Companies.
Limited liability companies (LLCs) are popular due to the flexibility and protections they afford to their investors (referred to as “members”). A Texas limited liability company is formed through the filing of a certificate of formation with the Texas Secretary of State. Its management may either be through its members or through manager-members. See Tex. Bus. Org. Code § 101.251.
Unless the operating agreement states otherwise, members are limited in their total investment loss. By statute, members of an LLC may incur losses only up to each individual member’s contribution to the LLC. See Tex. Bus. Org. Code § 101.114.
Members also have some flexibility in determining the federal tax treatment of the LLC’s business activities. For example, a single-member LLC may choose to be treated as either a disregarded entity, an S corporation,[iv] or a C corporation. Other LLCs with more than one member may choose to be treated for federal tax purposes as either a partnership, an S corporation, or a C corporation.
Limited liability companies are subject to Texas franchise tax. See Tex. Tax Code § 171.0002(a).
Professional Limited Liability Companies.
A professional limited liability company (PLLC) is an LLC that is formed for the purpose of providing professional services. Generally, professional services include personal services rendered by a dentist, attorney, physician, or veterinarian.
PLLCs are treated similarly to LLCs for state and federal tax purposes. They are subject to Texas franchise tax. See Tex. Tax Code § 171.0002(a).
Similar to sole proprietorships, general partnerships may be created without filing any formal organization paperwork. Indeed, all that is necessary in the State of Texas to form a general partnership is “an association of two or more persons [who] carry on a business for profit as owners[.]” Tex. Bus. Org. Code § 152.051(b). Sometimes general partnerships are formed even when the two partners do not recognize it as a general partnership.
Under Texas law, all partners of a general partnership are generally jointly and severally liable for all obligations of the partnership. Tex. Bus. Org. Code § 152.304.
Most general partnerships are treated as partnerships for federal income tax purposes.[v] General partnerships are subject to Texas franchise tax unless direct ownership is composed entirely of natural persons. See Tex. Tax Code § 171.0002(b)(2).
A Texas limited partnership is a partnership formed by two or more persons that has one or more general partners and one or more limited partners. Unlike a general partnership, a Texas limited partnership is only formed if a certificate of formation is filed with the Texas Secretary of State.
A general partner remains liable for the debts and obligations of the limited partnership. Tex. Bus. Org. Code § 153.152(b). However, the limited partners (as the name suggests) are not liable for the obligations of the limited partnership unless: (1) the limited partner is also a general partner, or (2) the limited partner participates in the control of the business. Tex. Bus. Org. Code § 153.102(a). But the limited partner is only liable under (2) to persons who transact business with the limited partnership and who reasonably believe, based on the limited partner’s conduct, that the limited partner is a general partner. Tex. Bus. Org. Code § 153.102(b). There are also a litany of exclusions which permit a limited partner to not be treated as participating in the control of the business in certain instances. Tex. Bus. Org. Code §§ 153.103; 153.104
Limited partnerships are taxed similarly to general partnerships. However, because limited partners are limited in their liability to the partnership and third parties, special federal tax rules apply to the allocation of certain debt to these partners, which may limit the amount of their deductible losses.
Limited partnerships are subject to Texas franchise tax.[vi]
Limited Liability Partnership.
A Texas limited liability partnership is similar to a limited partnership except it also provides liability protection to its general partner. Tex. Bus. Org. Code §§ 153.353; 152.801. Because the limited liability partnership limits the liability of the general partner, special federal tax rules apply to the allocation of certain debt to these partners, which may limit the amount of their deductible losses.
LLPs are subject to Texas franchise tax. See Tex. Tax Code § 171.0002(a).
A Texas corporation is formed through the filing of a certificate of formation with the Texas Secretary of State. Corporations provide shareholders with limited liability—however, corporations are also subject to two levels of tax: first at the corporate level,[vii] and a second time at the shareholder level when dividends are distributed from the corporation to shareholders.[viii]
A Texas corporation can be a professional corporation (PC). A PC is formed for the purpose of providing a professional service that by law a for-profit or nonprofit corporation is prohibited from rendering. Only a professional individual licensed to practice the same professional service as the professional corporation may be a governing person or managerial official of the PC.
Corporations can avoid the double level of taxation through filing an election with the IRS to be treated as an S corporation. If the election is effective, the corporation is generally only taxed once by way of flow-through items of income to the shareholders. When distributions are made by the S corporation to its shareholders, the shareholders are not taxed again, provided they have sufficient basis in their stock of the S corporation.
Corporations are subject to Texas franchise tax. See Tex. Tax Code § 171.0002(a).
As the above comparison shows, business owners and entrepreneurs have many options in ensuring their choice of entity aligns with their business and financial goals. But, with added flexibility comes added complexity.
For other resources on choice of entity, see Choice of Entity After Tax Reform.
[i] The sole proprietor must request an assumed name certificate (referred to as a DBA) in the county where the business is located if the sole proprietor intends to operate under another name than the sole proprietor’s surname.
[ii] For example, if the sole proprietor has employees, the IRS may seek directly from the sole proprietor all unpaid employment taxes. Conversely, if the owner operates under an entity umbrella, the IRS is generally limited to seeking only the trust fund portion of the unpaid employment taxes from the owner because the other portion of employment taxes represents a debt of the entity and not the sole proprietor. See also 26 U.S.C. § 6722.
[iii] Franchise tax is computed based on a taxable entity’s margin. Generally, the taxable entity’s margin is computed in one of the following ways: (1) total revenue times 70%; (2) total revenue minus cost of goods sold (COGS); (3) total revenue minus compensation; or (4) total revenue minus $1,000,000. The tax rate for 2020 is .75%, unless the business is in retail or wholesale.
[iv] However, to be characterized as an S corporation, it must meet additional requirements under the Internal Revenue Code. Specifically, it must have no more than 100 shareholders; its shareholders must be natural persons, estates, or certain trusts; it must not have a nonresident alien as a shareholder; and it must have only one class of stock. See 26 U.S.C. § 1361.
[v] Because Texas is a community property state, a general partnership owned solely by husband and wife as community property may be treated as either a disregarded entity or a partnership. See Rev. Proc. 2002-69; CCA 2008852001.
[vi] There is an exception in which the franchise tax is not imposed on a limited partnership if the limited partnership meets the requirements of a “passive entity.” See Tex. Tax Code §§ 171.0002(b)(3); 171.0003.
[vii] Currently, corporate tax rates are 21% of taxable income. See 26 U.S.C. § 11.
[viii] Currently, qualified dividend rates are 0%, 15%, or 20%, depending on the shareholder’s other income and marital status. See 26 U.S.C. § 1(h)(11).