By Andy Tiwari
Most business owners know that they should have a business entity such as a corporation, limited liability company, or registered partnership, but many business owners don’t understand exactly why they should file or create an entity.
In the vast majority of cases, asset protection continues to be the primary reason for incorporating or forming a registered partnership. When done correctly, this allows a business owner to separate his or her personal assets from the assets of the business in which they hold an ownership interest. Thus, the business owner can protect him or herself from losing things like the family car, that special diamond pendant, or the vacation house. However, there are numerous misconceptions about the extent of this protection and it is imperative that clients understand what the limitations of business entities are, especially with regard to what pitfalls exist regarding individual liability.
In addition to understanding how to use a business entity properly, accomplishing your goals requires understanding what entity is right for your business and why. The Texas legislature enacted sweeping changes to Texas’ Franchise Tax in 2005. Prior to that change, many organizations in Texas made use of various structures that combined partnerships, corporations, and/or limited liability companies in order to take advantage of the old law provisions that exempted partnerships from franchise tax liability. One well known computer manufacturer based in Texas used this loophole to virtually eliminate its franchise tax liability.
Those “loopholes” haven’t applied for nearly six years now and yet many business clients we encounter still maintain the now unnecessary structure they established to take advantage of those loopholes. As a result, those businesses pay increased costs in accounting and maintenance. Our firm can assist businesses in streamlining their corporate structure to reduce accounting costs, among other things.
In addition, there are still exceptions to the margin tax for certain types of entities depending on the type of business being conducted and the manner in which the business is conducted. As noted in our discussion on S Corporations , the Limited Liability Company has become a popular choice based on its flexibility and is frequently the entity of choice. Of course, it is not always the BEST choice for your particular situation. For example, if you are purchasing a tract of land for development in Texas, your interests may be better served by forming a registered partnership if you intend to passively own that land for a few years.
Incorporation or registration is only one step in the process; drafting a well tailored set of bylaws, an operating agreement, or partnership agreement is equally as important, especially when an entity has multiple owners. Though unpleasant concepts to dwell upon, a well drafted agreement avoids expensive or protracted disputes in the future by answering questions like: what happens to your shares if you become disabled? Can your partner’s ex-spouse come in and manage the business after your partner’s divorce? If you have a dispute and want to leave the company, how will that process be done? Can you be compensated for your ownership if you leave and, if so, how much will your ownership interests be worth? What do you do about your business partner’s violations of a board’s rules of ethics? What happens if the owners have to guarantee a loan for the business? How do you value a company with only a few assets? (See our pages on Business Documents and Maintenance and Contracts ).
There are default answers to some of these questions contained in the Texas Business Organization Code, and the Texas legislature has done a commendable job of creating a decent “fall back plan”. However, any agreement that you have prepared and enter into will control over nearly all of the fall back provisions Texas law provides. For example, if you have no clue about construction but enter into a business relationship with a construction specialist, you may want to retain management rights while allowing your business partner to be able to freely enter into certain building contracts without your approval. Under the default provisions of Texas law, this isn’t possible. Conversely, you may want to prevent your business partner who has been through three bankruptcies from entering into a contract that could cost the company more than $1.00 without informing you first. While that last example is rather extreme, the concept is not: the default provisions of the law typically won’t help you in that scenario, but a well drafted agreement for business operations can.
A brief word on incorporation packages: can you safely use an incorporation service to incorporate online? Yes. Do you necessarily need an attorney to incorporate your business? No. Are there possible advantages to be obtained by working with an attorney? Well, as you may have guessed, the answer is a resounding “yes”. If you’re a business owner with a sophisticated working knowledge of business entities, you can probably navigate the incorporation process on your own. If not, contacting an attorney offers you several potential advantages. As mentioned, the fact that your successful business owner- friend has an “S-Corp” doesn’t mean that you should use the same corporate structure. Incorporation services don’t ask you about the type of business you’re operating, the level of exposure to risk that you anticipate, or how you want your buy-sell agreement structured. Also, not all incorporation services are the same: some are very good at what they do and update their kits routinely; others, including some rather prominent services, lag behind and we’ve frequently reviewed corporate documents for clients who’ve used online or package incorporation kits and found glaring errors resulting from the use of one boilerplate contract too many.
A quick word about costs: online incorporation companies routinely fail to disclose the actual cost of setting up your business. After the ‘bells and whistles’ are added, you may be surprised to see that your online option that should have cost less than working with an attorney is in fact equally or more expensive!
If you’re thinking about starting a new business, or if you’re already in business and are wondering about whether you’ve got the right structure or agreement in place, let us help you answer your lingering questions.