Forming a Corporation
Choosing the Business Entity
The selection of a type of business ownership is a decision that a person should make, in consultation with an attorney and an accountant, and taking into consideration issues regarding tax, liability, management, continuity, transferability of ownership interests, and formality of operation. Generally, businesses are created and operated in one of the following forms:
The most common and the simplest type of business ownership is the sole proprietorship. In a sole proprietorship, a single individual engages in a business activity without necessity of formal organization. If the business is conducted under an assumed name (a name other than the surname of the individual), then an assumed name certificate (commonly referred to as a DBA) should be filed with the state or county. A sole proprietorship is not considered to be an entity separate from the owner, may not be owned by more than one person, and provides no protection against liability to the owner. Sole proprietorship income is reported on Schedule C of the owner’s Form 1040. Profits are treated as income of the owner, and losses are deductible to the owner. A sole proprietorship does not pay the state franchise tax. The business may not be sold as an entity, but its assets may be sold. The sole proprietorship may be shut down at any time. There is no need to dissolve anything or to file any paperwork.
A general partnership is created when two or more persons associate to carry on a business for profit. A partnership generally operates in accordance with a partnership agreement, but there is no requirement that the agreement be in writing and no state-filing requirement. Unless otherwise agreed (and this should be in writing), all partners have equal ownership, equal rights to distributions of profits, and equal say in management. Partnership are usually terminable at will or at the death of any of the partners, and partnership interests cannot be sold or transferred without the consent of the other partners. Partnerships are considered in most states to be an entity separate from the partners, so that a partnership can own property and sue and be sued in its own name. However, a partnership provides no liability protection to its owners. In fact, each partner is jointly and severally liable for all debts of the partnership, including for the misconduct of their partners. General partnerships report their income to the IRS in a Form 1065; however, partnerships do not pay taxes. Rather, each partner’s share of the profits or losses is reported on a Form K-1. Each partner’s share of the profits is taxed as income of that partner, and each partner’s share of any losses is deductible. There are no filing requirements for a general partnership. General partnerships do not pay the state franchise tax.
Formation of a corporation requires filing documents with the state government. A corporation is a legal person, separate from its owners, with the characteristics of limited liability, centralization of management, perpetual duration, and ease of transferability of ownership interests. The owners of a corporation are called “shareholders.” The persons who manage the business and affairs of a corporation are called “directors.” However, state corporate law does provide for shareholders to enter into shareholders’ agreements to eliminate the directors and provide for shareholder management. Choosing the best management structure for your corporation is a decision you make with the advice of an attorney. Shareholders are not liable for the debts of the corporation. Ordinarily, a corporation is a tax-paying entity, which reports its income on a Form 1120. Shareholders do not pay taxes on corporate income; nor are corporate losses deductible by the shareholders. However, if the corporation distributes its excess profits to its shareholders through a dividend, then that money is taxed twice: First, the corporation pays income tax on the profits; then the shareholder pays income tax on the dividends. To eliminate double taxation, the Tax Code provides that certain small corporations may elect to be taxed like partnerships by making a “Subchapter S” election. The corporation then reports its income on a Form 1120S (similar to a partnership’s Form 1065), but each shareholder’s proportionate share of the profits or losses are reflected and taxed on the shareholder’s individual tax return. A corporation may be sold as an entity, with all assets and liabilities included. A corporation’s Certificate of Formation must be filed with the state along with annual public information reports that are submitted with the franchise tax.
Statutory Close Corporation
The Texas Business Organizations Code permits the organizers of a corporation to elect to be a statutory “Close Corporation” in the Certificate of Formation when the corporation is first formed. A statutory close corporation is the same as an ordinary for-profit corporation, except in its management and in provisions made in the statute for the resolution of disputes that do not apply to ordinary corporations. A close corporation ordinarily does not have a board of directors and is managed directly by the shareholders. The tax status of a close corporation is the same as an ordinary corporation; however, statutory close corporations will almost always qualify for the Subchapter S election.
An “S” corporation is not a matter of state corporate law but rather a federal tax election. S Corporations are exactly the same as other corporations (“C Corporations”) in terms of their organization and treatment under state law. A for-profit corporation elects to be taxed as an “S” corporation by filing an election with the Internal Revenue Service. Shareholders should contact the IRS or consult with competent tax counsel regarding the decision to be taxed as an “S” corporation and the requirements for filing the election. Federal law restricts the number and type of shareholders who can own stock in an S Corporation. If a corporation elects to be an S Corporation, then it is taxed exactly like a general partnership.
Limited Liability Company
A limited liability company is created by filing documents with the state. The limited liability company (LLC) is not a partnership or a corporation but rather is a distinct type of entity that has the powers of both a corporation and a partnership. Depending on how the LLC is structured, it may be likened to a general partnership with limited liability, or to a limited partnership where all the owners are free to participate in management and all have limited liability, or to an “S” corporation without the ownership and tax restrictions imposed by the Internal Revenue Code. The owners of an LLC are called “members.” A member can be an individual, partnership, corporation, trust, and any other legal or commercial entity. Generally, the liability of the members is limited to their investment, and they may enjoy the pass-through tax treatment afforded to partners in a partnership. As a result of federal tax classification rules, an LLC can achieve both structural flexibility and favorable tax treatment. Nevertheless, persons contemplating forming an LLC are well advised to consult competent legal counsel. A limited liability company can be managed by managers or by its members. The management structure must be stated in the certificate of formation. Management structure is a determination that is made by the LLC and its members. The chief distinguishing characteristic of the LLC is the Company Agreement. Shareholder Agreements in corporations are not very common, but every LLC by definition has a Company Agreement. If that agreement is not in writing and signed by all of the members (a very bad practice), then the court must reconstruct the Company Agreement by using the default provisions of the Code and the oral agreements of the members that can be proven. An LLC is a much more flexible vehicle for organizing a company than is a corporation. Virtually all the provisions of the Code governing LLCs may be altered in the Company Agreement. All members must unanimously agree to any amendment of the Company Agreement unless they waive that right. LLCs must file their Certificate of Formation and annual reports similar to corporations and are subject to the state franchise tax like corporations.
A limited partnership is a partnership formed by two or more persons and having one or more general partners and one or more limited partners. This type of business ownership operates in accordance with a partnership agreement, written or oral, of the partners as to the affairs of the limited partnership and the conduct of its business. While the partnership agreement is not filed for public record, the limited partnership must file a certificate of formation with state. General partners are fully liable for the debts of the partnership, while limited partners are not liable for the debts of the partnership, but may not participate in management of the business. Limited partnerships are taxed exactly like general partnerships.
Limited Liability Partnership
In order to limit the liability of its general partners, most states permit a general partnership to opt to register as a limited liability partnership. Legally, the limited liability partnership is exactly the same as a general partnership, except that general partners are not held liable for claims against the partnership in which they had no personal involvement. Limited Liability Partnerships are taxed exactly like general partnerships. A certificate electing limited liability status must be filed with the state.
Professional Business Organizations
Professional business organizations – professional corporations (PCs) or professional limited liability companies (PLLCs) – are provided by statute to carry on businesses that require a professional license, such as lawyer and doctor practices. The Code provides a few quirks for these types of organizations, such as the prohibition on any non-licensed individual to own an interest in the organization and the inability of professional shareholders or members to sue for fraud relating to their investment, but for the most part professional organizations are formed, operate, and are taxed exactly like non-professional corporations and LLCs
Choosing Among the Different Types of Business Ownership
Choosing among the types of business ownership involves a balancing of competing concerns. In the start-up phase of a new closely-held business, when the company is probably losing money, "pass-through" tax structures (general partnership, limited partnership, limited liability partnership, S-corporation, or limited liability company) are preferable. Most of these structures have some disadvantages if the entity is successful and wishes to grow and attract capital from outside investors. Partnership structures provide the best legal protection to minority owners but leave all the owners exposed to unlimited liability. Limited partnerships shield limited partners from liability, but limited partners are prohibited from active participation in management. Limited liability partnerships shield some partners from liability but only if they have no involvement in the transaction creating the debt or liability. The most useful type of business ownership for large and growing organizations is the corporation, which combines limited liability, separation of ownership and control (allowing for passive investors) and permanence. The limited liability company is the newest type of business ownership and was created by the legislature as a hybrid to get the best of both worlds: limited liability and pass-through taxation. The caveat for business owners setting up an LLC is that these companies are designed to be primarily governed by contract. There are fewer rules and much more legal uncertainty regarding these organizations than with corporations. Therefore, the governance and operations of an LLC needs to be carefully thought through and planned and detailed in an operating agreement.
The person who actually files the certificate of formation with the Texas Secretary of State creating a corporation is referred to as the “organizer,” [Sec. 3.004] which is synonymous with the pre-Code term “incorporator.” [Sec. 1006 (14)] Any person having the capacity to contract for the person or for another may be an organizer for a Texas corporation. [Sec. 3.004(a)] The organizer need not be a Texas resident. The organizer may or may not have any ownership interest in the corporation [Jernigan v. State, 589 S.W.2d 681, 685 n.3 (Tex. Crim. App. 1979) (“It is axiomatic that an incorporator need not own any portion of the capital stock of a corporation.”)] and may be simply the corporate attorney retained to draft and file the forms.
Each organizer must sign the certificate of formation. [Sec. 3.004(b)] Once filed, the organizer, as such, ceases to have any role, authority, or power over the entity. That power and responsibility vests in the initial board of directors who actually organize the corporation at the organizational meeting. [See Sec 21.059(b).]
Reservation of names
Any person may file an application with the secretary of state to reserve the exclusive use of a corporate name. [Sec. 5.101(a).] The application must be signed by the applicant or an agent or attorney and be accompanied by the required filing fee. [Sec. 5.101(b).] A name may not be reserved if it is the same or deceptively similar to the name of an existing entity or another name that is reserved or registered, unless the entity with the right to the name provides to the secretary of state a notarized written statement of consent to the reservation of the similar name. [Sec. 5.102.] The secretary of state is required to reserve the name specified in the application for the exclusive use of the applicant upon determination of eligibility [Sec. 5.103] until the earlier of the 121st day after the application was accepted for filing or the date the applicant files a written notice of withdrawal of the application. [Sec. 5.104. No fee may be imposed for filing a notice of withdrawal. Sec. 5.1041] The reservation may be renewed for successive 120-day periods by filing a new application and paying the filing fee during the 30-day period prior to the expiration of the reservation. [Sec. 5.105.] Also a person may transfer the reservation of the name by filing a notice of transfer with the secretary of state, which is signed by the person for whom the name is registered and states the name and address of the transferee. [Sec. 5.106.]
Registration of the name
A domestic corporation does not need to register its name. This is done by stating the name of the corporation in the certificate of formation. Foreign entities do need to register their names. [See Sec. 5.151.]
Rights to the name
The filing of a certificate of formation or the reservation or registration of a corporate name does not authorize the use of the name in violation of a right of any under federal or state trademark laws or common law. [Sec. 5.001]
Letter of consent
If the name in the certificate of formation or in the reservation is similar to that of another business, then the secretary of state will require a letter of consent from the entity with prior rights to the name. The letter of consent requirement may not be waived, even if the other entity is no longer in business. [1 Tex. Admin. Code § 79.41(a) (“A proposed name which is deemed to be similar requiring letter of consent cannot be filed without a letter of consent. No waiver of a required letter of consent will be allowed even though it may appear that the existing entity is not actively engaged in business, is about to change its name, be dissolved, forfeited, or merged out of existence.”).]
No particular form of consent is required. The consent must be in writing and signed by an officer or authorized agent of the consenting entity. Consent given orally cannot be accepted. Consent from more than one entity may be required in some instances. The letter of consent must not state conditions; it must give unequivocal consent. [See 1 Tex. Admin. Code § 79.42.]
Filing the certificate of formation
The act that creates a Texas corporation is the filing of the certificate of formation. [Sec. 3.001(a).] The corporation’s legal existence takes effect upon filing. [Sec. 3.001(c).] Except in a proceeding by the state to terminate the existence of a corporation, an acknowledgment of the filing of a certificate of formation issued by the Texas Secretary of State is conclusive evidence of: (1) the formation and existence of the corporation; (2) the satisfaction of all conditions precedent to the formation of the filing corporation; and (3) the authority of the corporation to transact business in this state. [Sec. 3.001(d).]
The principal function of the initial board of directors, named in the certificate of formation, is to complete the formation of the corporation. Except in a corporation created as a result of a conversion or merger plan that states the bylaws and names of the officers, the corporation is required to hold an organizational meeting, after the filing of the certificate of incorporation, called by a majority of the board of directors, for the purpose of adopting bylaws, electing officers, and transacting other business, such as issuing shares and setting up authority for bank accounts, etc. [Sec. 21.059(b). If the corporation is being managed without a board of directors, then the organizational meeting is called by a majority of the initial managers named in the certificate of formation.] The directors calling the meeting must send notice of the time and place of the meeting to each other director or person named in the certificate of formation. [Sec. 21.059(c).] Typically, and particularly in small corporations, there is no actual meeting. Rather, the attorney assisting in the formation drafts the minutes of the organizational meeting, including resolutions for all business needed to get the corporation organized, and the initial directors execute the minutes by written consent. [Sec. 6.021(b).]