Forming a Business: Texas Partnerships
Dallas, Texas is home to some of the world’s most savvy entrepreneurs. From small family operations to high growth middle market businesses and the Fortune 500, owners have worked long, hard hours to be successful in economic downturns and growth cycles alike. For all the planning that goes into accelerating revenue and improving the bottom line, I don’t normally encounter owners or executives that say, “I wish I could spend more money on lawyers.” In fact the opposite is universally true.
Whether you have just started to build a business, are growing your established business or have operated for many years, you may feel a level of trust with your associates and partners that you come to trust and rely on every day. At face value, you may think the arrangement you have with your business partner is fine the way it is: handshake agreements and maybe a long-standing relationship that has evolved from a bright idea to a successful and rewarding business. As a partner, you have good synergy in the relationship. You work well together, agree on most things, and share a common vision. With Texas-sized enthusiasm for your business, what could possibly go wrong?
Business Formation and Corporate Entities: Avoid the Avoidable
This isn’t the “Lincoln Lawyer” and not all business relationships are matches made in heaven. And those that may start out in total sync may evolve into something completely different. We hope not, but a lot of things happen when money and sweat are on the table. Proper consideration of legal and tax structures in the formation of your business enterprise may save you money, and certainly time and aggravation in the long run. One of the toughest experiences is a nasty business divorce that can not only drain financial resources but emotional resources too. The resulting collateral damage may directly and indirectly affect business, personal and family relationships.
Proper entity formation and corporate governance in all forms of business entities is essential to successfully operating a business, whether big or small. Adequate planning and good counsel is critical to minimizing risk to your business and personal assets.
While it is possible to do it yourself, it is best to form your Texas business entity with the help of a seasoned business lawyer to help ensure that all your bases are covered. And, while there may be cut-rate do it yourself resources available online that propose to solve all potential problems, as the saying goes, generally “you get what you pay for”. And certainly, not all problems will ultimately be resolved without controversy, but you owe it to yourself and your future to start with a rock-solid foundation.
It is not only important to properly establish and document your entity formation if you do not maintain the formalities of the organization you may find that an adversary in litigation may attempt to “pierce the veil”, find one personally liable and put your personal assets at risk. This brings potential business consequences to the home front and may expose you and your family to unnecessary, avoidable losses.
So, what type of entity is right for your business? In addition to experienced legal advisors, you should consult with your CPA or other tax advisors regarding the tax effect of the various forms of partnership structure.
An Overview of the Various Business Formation Entities
Sole Proprietorships. Many “mom and pop” type businesses are operated as sole proprietorships. There are other types of ownership generally thought of as similar to a sole proprietorship, such as joint ownership of property in various forms, co-ownership, undivided ownership or similar arrangements. A sole proprietorship may operate under an assumed name (with appropriate state and county filings), use an individual social security number to open a bank account, file taxes using the social security number of an individual and include liability for all debts and obligations (including tortious and negligent acts of owners and employees). This form of operation subjects the business owner’s personal assets to all risks, other than as may be covered through insurance products available for purchase (which can also be expensive and include numerous exceptions to covered risks).
Partnerships. A written partnership agreement provides a framework for the operation of small businesses and large organizations alike, outlines partner responsibilities to each other and to the business, and can offer a road map to follow when opportunities or internal problems arise that did not appear to be opportunities or issues in the early days of the business and owner or partner relationship.
If you have not entered in to a written partnership agreement, for instance in a general partnership, or have not addressed certain provisions in any agreement you do enter related to your entity of choice, your Texas partnership will likely be governed by the Texas Business Organizations Code (TBOC). Written to govern a wide variety of arrangements, the TBOC may not provide the best set of rules for your entity, which is why in many cases it allows the governing documentation of the entity to prevail. It is ultimately a backstop (together with current case law) that defines relationships that have not been otherwise determined between the parties. In the long run, it is a smart move to take the time and effort to create an entity and governing documentation that is tailored to your business, its needs and your personal interests.
A general partnership (GP) is the next step up from a sole proprietorship. In a general partnership, the partners will bear unlimited joint and several personal liability for debts and other obligations and liabilities of the general partnership. For instance you could be liable for the bad acts of your partner and employees of the general partnership, i.e. claims of discrimination, sexual harassment, negligence, damage to property from accidents or other perils and injury or death to individuals.
In a limited partnership (LP), there are both general partners and limited partners. One or more general partners will have control over the day-to-day operations of the limited partnership. Usually the general partner is structured as a separate entity itself, in the form of a corporation, limited liability company, or another limited partnership because the general partner is ultimately liable for all of the debts, obligations and liabilities of the limited partnership. Limited partners can be individuals or other entities because they do not share in the liabilities of the limited partnership unless they participate in the management of the limited partnership in their capacity as a limited partner. A limited partner that participates in the management of the limited partnership as an employee of the partnership or general partner does not lose limited liability status with respect to the debts, obligations and liabilities of the limited partnership and remains liable only for the amount of its investment in the partnership while the general partners continue to be burdened with full risk liability.
Limited liability companies (LLC’s) have gained popularity in Texas since they afford protection to members from liability in the same manner as a corporation but retains the tax advantages of a partnership. Members of an LLC can run the day-to-day operations of the LLC or they can provide for “managers” to run the day-to-day operations. These “managers” operate in a manner similar to the board of directors of a corporation.
An LLC can be classified as a sole proprietorship, a partnership or an association for federal income tax purposes. In the absence of making a subchapter “S” election the LLC would also have pass through taxes borne by the individual members. Your CPA or tax accountant is the best source for information regarding all tax consequences of your choice of entity.
Basic Information to Include in the Partnership and Limited Liability Company Agreements
Partnership and limited liability formation documents and agreements will include the name of the entity/partnership, the purpose of the entity/partnership, the members’/partners’ names, and how long the entity will remain in existence.
Other key components to include in the operating agreement or partnership agreement are:
- Roles of the members or partners
- General business responsibilities
- Required commitments of time (full-time vs. part-time)
- Required commitments of assets, money, etc.
- Distribution of income, profits and losses to the partners
- Conflict resolution procedures; discipline for misconduct of a member or partner, expulsion of a member or partner
- Procedures for the addition or withdrawal of members and partners
- Rules for buyout
- Rules in event of death of a member or partner
- Protocol for retirement
- Guidelines of transfer of interest to heirs, etc.
- Non-compete agreements, if any
- Dissolution procedures
- Financial matters
- Banking privileges
- Accounting methods and responsibilities
- Method of valuation of the entity, etc.
This list provides an overview of the items that should be considered carefully before entering into an operating or partnership arrangement in Texas, but this list is just meant as a jumping off point for more in depth discussions. Business partners are advised to consider the above issues in depth and to meet with a credible Dallas business attorney to get the terms of their operating or partnership agreement in writing. Ensuring alignment by keeping all parties on the same page is a strong and important early step toward success.
“C” Corporations. A “C” corporation is a regular corporation created under the TBOC by the filing of a Certificate of Formation with the Texas Secretary of State. Unlike an “S” corporation (where the income and losses of the corporation flow through to the shareholders) a “C” corporation is treated as a separate taxpayer. Today, few closely held corporations operate as a “C” corporation due to the double taxation nature of the entity. Profits of the “C” corporation are taxed at the corporate level, and any distributions to shareholders are taxed again.
“S” Corporations. A “S” corporation is very simply, a pass-through business entity. In this business structure, a company’s profits and losses both pass through the corporation and to the business owner’s personal income tax filing. In this capacity, it is important to fully understand how your personal income taxes paid for normal business operations and the deductions you might file will differ from a sole proprietorship.
How to Form the Business That Is Best Suited To You
There is a lot to consider and cutting corners may expose you and your family to unnecessary risk. You should work with your partners to define your business goals and objectives, considering what your personal needs may be as they relate to your business concept. Having an open and honest conversation with a business attorney may be one of the strongest and fastest ways to determine what makes the most sense. While the process may seem overwhelming, a qualified business attorney will be able to provide you with valuable advice for little time and investment.