Which Entity Should I Form for my Texas Business?
The Pros and Cons of Different Entity Types
by Ali A. Akhtar
Forming an entity is the first legal step for business owners, and it is important to do it correctly to avoid issues down the road. In this blog, I will give some insight into the main options for entrepreneurs and small business owners starting their businesses in Texas:
General Information for Forming an Entity (Corporations, LLC’s, and Partnerships)
Whether creating a corporation, LLC, or partnership, business owners must navigate through these key steps to ensure their entity is properly formed.
- Checking name availability with the Texas Secretary of State and filing a certificate of formation. Forms and resources can be accessed at their website, here.
- Selecting or being a registered agent. Should the entity be summoned, sued, or simply need to receive official paperwork, the registered agent is the point of contact for all legal service matters.
- Having an operating agreement that clearly outlines how much each owner is bringing to the table, ownership interests, and conditions for withdrawal from the business.
- Getting an EIN (Tax ID) from the IRS. Scam companies will offer to provide these for a fee, but business owners can always get theirs for free with the IRS, here.
- Receiving a State Tax ID number from the Texas Comptroller. An entity is responsible for filing and paying an annual franchise tax in Texas. Depending on the nature of the business (selling certain goods or services), it may also have to collect and pay sales and use tax. Information and resources can be found on the Texas Comptroller’s website, here.
Advantages and Disadvantages of a D/B/A (Sole Proprietorship)
D/B/A stands for “doing business as,” which in legal terms signifies that the individual is “doing business as” a company, but there is no legal separation between the individual and the business. This is also often referred to as a sole proprietorship.
Forming a D/B/A is easier and cheaper to do upfront, and an important option for those looking to start their business quickly. Establishing the entity is as simple as filing an assumed name certificate with the County Clerk in your county (residence or business location). There’s no required registration with the Texas Secretary of State. The lack of legal hoops to jump through make for easier ongoing maintenance. A D/B/A does not pay Texas franchise tax or have annual reporting requirements, meaning less paperwork during tax season.
However, these advantages may be offset by the lack of tax savings. As a D/B/A, business owners will be subject to full self-employment taxes, and all profits (i.e., revenues minus expenses) will be taxed at your personal household income tax rate.
It’s crucial to understand that a sole proprietorship is not a separate legal entity, meaning its formation does not create any liability protections. Business owners who’ve formed their entity as a D/B/A can be personally held responsible for all debts and liabilities of the business.
Advantages and Disadvantages of an LLC
A limited liability company (LLC) is the most flexible type of entity and has become the most popular choice for new business owners. If the owner is the sole member, the entity operates just like a sole proprietorship but offers tax and liability advantages. Creating a separate legal entity and shielding one’s personal assets is a significant consideration for many owners, depending on the risk profile of their business.
Owners who form an LLC often elect to be treated as an S-Corp, meaning they are both the owner and employee of their business. By doing so, they save on self-employment tax by drawing a reasonable salary and having tax withheld from their payroll as a W-2 employee. Additionally, they can take a distribution of profits from the LLC as the owner. The LLC does not pay federal taxes on its income, only the owner/employee pays taxes on what he or she earns or withdraws. That’s why, for tax purposes, it’s called a “pass-through” entity.
Of course, these tax advantages come at the expense of more paperwork and ongoing effort. Filing an LLC has a higher upfront fee, and registered agents must maintain and update their address in Texas. Reporting requirements, such as annual reports for the Texas Comptroller and the Public Information Report (PIR), exist for every LLC in Texas. These documents can be filed together at the same time by the annual deadline (generally, May 15) through a Texas Comptroller online account.
All business owners have their own preferences, and every business model is unique. For example, my solo law practice is a sole proprietorship; I’m not incorporated nor do I have an LLC. I enjoy “doing it myself” (i.e., my accounting/bookkeeping, distributions, and quarterly estimated taxes), and since I already maintain professional liability (i.e., malpractice) insurance, I’m not worried about the personal liability issue. I’ve also registered a separate EIN for my law practice so that I’m not using my Social Security Number on W-9’s and other documents.
Although this blog provides a helpful legal understanding of the pros and cons of different entity types, it’s crucial that new business owners spend time considering their business model and other factors before making a decision. Of course, they should also consult with a qualified accountant and tax professional before making a final decision.