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CHOICE OF LEGAL ENTITY (continued) The most complex of the taxing patterns imposed by the Internal Revenue Code is that applying to partnerships. The goal is to make partnership taxation as close to individual taxation as possible. The partnership provisions try to make income, deductions, credits, and other tax items the same in the hands of a partner as they would be if the partner were a sole proprietor. Though taxation may be complicated as a partnership, the partnership itself is comparatively simple and it can be the most flexible. The partnership agreement can contain almost any provision desired; income and deductions can be allocated in any manner the partners choose. (These allocations must make economic sense, however, before they will stand up for tax purposes).  Partnerships have no limit on their size or on the number of their members. Property may be contributed and taken out without tax consequences.   The major tax drawback of the partnership form is the inability to deduct the cost of certain fringe benefits given to partners.  A profit-sharing or pension plan may not be adopted for the benefit of the partners, but a comparable plan—the Keogh plan—is available to partners on an individual basis.  Lack of a qualified plan is no longer a major reason for choosing corporate form.  As for the remaining benefits that are not available as deduction to a partner, that condition has not deterred professionals from choosing the partnership form.   Limited Partnership.  A limited partnership is a partnership formed by two or more persons or entities, under the laws of Texas, and having one or more general partners and one or more limited partners. General partners share equally in debts and assets, while limited partners have limited debt obligations. A limited partnership must be registered with the Secretary of State.    A limited partnership affords greater protection to the limited partners than is afforded to members of a Registered Limited Liability Partnership. In a limited partnership, the general partner (which may be a corporation) has unlimited liability and exposure for the limited partnership’s debts and obligations. Members in an LLC have no such exposure.   Generally, limited partners are not liable for the limited partnership’s debts and obligations unless the partners have actively engaged in the management of the business. A registered limited liability partner, on the other hand, may participate in the management or control of the partnership business and still enjoy the limited liability afforded by the RLLP.   The advantage of a Limited Partnership limits the rights of a judgment creditor to a charging order against only the income produced from that partner's interest in the partnership. The creditor may seek the appointment of a receiver to take the debtor's share of the partnership's profits.  To the extent that a partnership interest is charged in this matter, the judgment creditor only has the rights of an assignee of the partnership interest. Therefore, if the general partner has the right to hold a distribution of income pursuant to the Limited Partnership Agreement, the judgment creditor may receive nothing for his or her interest in the limited partnership that the creditor has obtained.   Registered Limited Liability Partnership.  A registered limited liability partnership (RLLP) is a general partnership that has been registered with the Secretary of State.  A partner's liability in a registered limited liability partnership differs from that of an ordinary partnership. In a registered limited liability partnership, like a general partner, an RLLP partner is liable for general partnership debts and obligations, however, an RLLP partner is not liable for the negligence or malpractice of other RLLP partners in his or her partnership unless he or she was involved in or aware of the negligent act.  A partner in a general partnership is liable for all other partner’s actions in the partnership even if he or she had nothing to do with the negligent action.   Registered limited liability partnerships, like general and limited partnerships, do not pay the Texas franchise tax. LLCs, on the other hand, must pay the franchise tax.   RLLP’s allow pre-existing partnerships to enjoy similar benefits to those afforded LLCs. Due to the tax consequences of disbanding a partnership and then forming an LLC, many pre-existing partnerships will prefer to chose the RLLP form instead. An RLLP has many of the same benefits of an LLC but avoids the tax consequences of changing the organization of a pre-existing partnership. For example, large firms that desire the benefits of an LLC but are wary of the tax consequences can form a RLLP.   Family Limited Partnership.  Is a Limited Partnership but centered around the idea of protecting the family assets while retaining control of the management, supervision and transferability of the property interests.  The partnership consists of the family members and can be an alternative to probate.    Limited Liability Company. A limited liability company is an unincorporated business entity which shares some of the aspects of Subchapter S Corporations and limited partnerships, and yet has more flexibility than more traditional business entities. The limited liability company is designed to provide its owners with limited liability and pass‑through tax advantages without the restrictions imposed on Subchapter S Corporations and limited partnerships. A limited liability company must be registered with the Secretary of State.   An LLC is created in the same manner as a corporation. Articles of organization are filed that show the full liability of each organizer. Assets of the individual members are not available for the company’s obligations beyond what has been contributed. The LLC merges the limited liability of a corporation with the tax advantages of a partnership or sole proprietorship.   The theory behind the LLC is that it will be taxed as a partnership. That result, however, depends on the manner the company is formed and operated. In Texas, the LLC can be formed in a manner that will allow it to act like a corporation as it may have long terms of life, a transferability of interests, or a centralization of management pattern that permits it to operate like a corporation.  Texas LLC’s are taxed as a partnership rather than as a corporation and they must pay a state franchise tax.    Whatever its drawbacks, it is likely the LLC will eventually be the entity of choice for most small and medium-sized businesses.   Professional Limited Liability Company.  Is like and LLC, however it is organized for the sole purpose of rendering one type of professional services and that has as its members only professional individuals or professional entities.  The rendering of the professional service requires that the prior to rendering of the service, the member must obtain a license, permit, certificate of registration, or other legal authorization.  Professional services include, but not limited to, services rendered by an architect, attorney, certified public accountant, dentist, doctor, or veterinarian.    Sole Proprietorship.  A sole proprietorship exists when a single individual operates a business and owns all assets.  A sole proprietor is personally liable for all debts, and business ownership is nontransferable.  Under a sole proprietorship, the life of the business is limited to the life of the individual proprietor.  The sole proprietorship makes no legal distinction between personal and business debts, and it does not require a separate income tax return. A sole proprietorship is operated under the name of the owner, or an Assumed Name Certificate must be filed with the county clerk.     Assumed Name Certificates or Doing Business As (d/b/a).  If the business will operate as a sole proprietorship or a general partnership, an Assumed Name Certificate or a dba Certificate for each name (or deviation of that name) the business will use must be on file with the county clerk in each county where a business premise will be maintained. If no business premise will be maintained, it should be filed in each county where business will be conducted.   If the business will operate as a corporation, limited partnership, or limited liability company, and the business will be identified by a name other than the name on file with the Secretary of State, an Assumed Name Certificate must be filed with the Secretary of State and each county in which the business will have a registered or principal office.   Neither the filing of an Assumed Name Certificate nor the reservation or registration of a company name imparts any real protection to the party filing the certificate. It is merely a formal process that informs the general public of the registered agent for a business and where official contact with the business can be made.   Joint Venture.  A joint venture is not a specific type of tax entity. Its tax classification is drawn from its manner of formation and operation. Though a joint venture can take almost any recognizable tax form, most joint ventures are either partnerships or corporations.  Joint ventures can, under some circumstances, ignore their association and retain their individual tax status for the operation.   Partnership status. Unless incorporated, most joint ventures are taxed as partnerships. Those ventures that do not incorporate choose that route to avoid corporate taxation. They purposely elect to be a partnership so the income and deductions of the venture will flow through to the venturers in their original tax form. Capital gain will not be turned into ordinary income when paid out as a dividend, for example. Such deductions as depreciation are directly deductible by the venturers if the partnership form is used.   The Code definition of a partnership includes "a syndicate, group, pool, joint venture, or other unincorporated organization . . . which is not . . . a trust or estate or a corporation."  No distinction exists between a partnership and a joint venture that is taxed like a partnership. Both are subject to the same tax treatment.  Exemption from partnership status is available only if all members of a joint venture make that election. The election is denied if the income of the members cannot be determined without the use of partnership accounting principles.    Associations taxable as a corporation. While a joint venture may begin as a partnership, it must avoid the characteristics of a corporation if it is to maintain partnership status. Once a partnership has more corporate than partnership characteristics, it is subject to reclassification as an association taxable as a corporation.   Six characteristics decide whether a venture is a partnership or an association taxable as a corporation.  Two of these are common to both partnerships and corporations. These are associations and the conduct of a profit-seeking venture. The remaining four therefore decide the tax nature of a venture. These are continuity of life, centralized management, limited liability, and free transferability of interests. If three out of these four are present, the venture is taxed like a corporation. If only two are present, it is a partnership.   Continuity of life is present if the death, retirement, or withdrawal of a member does not cause dissolution. If it does, continuity is not a characteristic of the venture. Centralized management exists if a small group has the sole authority to make management decisions. Centralized management also exists if substantially all the interests are owned by limited partners. If interests in the venture can be transferred freely, this is a corporate characteristic. If a transfer dissolves the venture, the interest is not freely transferable.    Co-ownership of property. Mere co-ownership of property, even as a joint venture, does not always lead to taxation as either a partnership or as a corporation. Co-ownership of property, by itself, merely requires that each co-owner pick up his share of income and expense from the property. The co-owners are only investors. Even when taxpayers who are not co-owners of property unite for a project, they are not necessarily partners.  For example, if persons organize to dig a ditch to drain their respective property, no income is involved, only expenses.  They will report the expenses in their own individual tax returns, not through a partnership return.  When co-owners of a residence jointly lease it, they are not engaged in business.  Once those owners go beyond merely holding and renting property, however, they are in business and are treated differently under the tax law. If they provide services for the residence—cut the grass, haul the garbage, etc.—their tax status changes.   General IRS Tax Classification.   Professional Associations.  As noted above, there are a variety of entities available to a professional who is engaged in plying his or her occupation. While these may all be classed as professional associations, for tax purposes, the term lacks specificity. The Internal Revenue Code does not recognize such an organization. Instead, the Code deals with:  Sole Proprietorships; Partnerships; Professional Corporations; Limited Liability Companies; Associations taxable as a corporation; Subchapter S corporation.   As this listing show, a professional association does not exist for tax purposes. A professional association is taxed like the specific tax entity whose form has been assumed. If it is a partnership, a limited liability company, or an S corporation, the tax governing pattern is that imposed on an individual. If it is a corporation or an association taxable as a corporation, it is taxed under the corporate rules.   However, if one of these entities assumes too many corporate aspects, it is taxed as a corporation. This is also true of partnerships and any other association of professionals. Depending on their formation and their operations, they may be taxed either as a corporation or a partnership.  Therefore the respect for following corporate formalities is important not only for tax reasons but for protection against individual liability.   Professional Service Corporations. Not only does the tax law not recognize a professional associations, it does not even acknowledge that a professional corporation is unique. For tax purposes, a professional corporation is the same as any other corporation.  The IRS does, however, recognize the individuality of most professional corporation in an indirect fashion. The IRS Code has set up a tax classification called "personal service corporations."  Most professional corporations are also personal service corporations. They are therefore subject to special rules affecting these entities.   The definition of a personal service corporation (PSC) varies, depending on the particular Code restriction imposed. Basically, a PSC is one engaged in giving services performed primarily by its employee-owners. Substantially all the stock of the corporation (at least 95 percent) must be owned by the employee-owners. For certain rules to apply, that definition is enlarged. Those rules will apply only if the corporation is engaged in certain fields. The fields are health, law, engineering, architecture, actuarial science, accounting, performing arts, and consulting.  The breadth of that listing includes most professionals. Still a third batch of rules applies only to employees who own 10 percent or more of the stock of the corporation. We hope the above summary will assist you in deciding what type of entity is right for you. Please be advised that the above is only a partial summary of each entity.  This area of law is very complicated so please feel free to consult further with us and/or your tax expert to determine which entity is right for you.  We look forward to answering your questions.  Article Adapted From Westlaw and the Texas Secretary of State Back to top