Texas Business Structures and their Federal Tax Treatment

There are many different business structures that can be formed in the state of Texas. The best structure for a business is based on a number of factors, including (but not limited to): the number of individuals forming the business, how the business will be governed, and the type of tax treatment of the business. While some business structures have only one possible tax treatment, others have different options for tax treatment. Below is a description of some of the primary business structures in Texas, including the way they are taxed by the Internal Revenue Service (“IRS”).

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Sole Proprietorships

A Texas sole proprietorship is the most common and simplest form of a business. This type of business structure has one individual owner who engages in a business activity and has no need of formal organization. If the business is formed under an assumed name (a name other than the surname of the individual owner), then an Assumed Name Certificate (“DBA”) should be filed with the County Clerk in the county where the business is located.[1]

How are Sole Proprietorships taxed?

The profit or loss from the sole proprietorship is reported on the owner’s individual income tax return, using Schedule C on Form 1040. The owner is also subject to self-employment taxes.[2]

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Partnerships

General Partnership: A Texas general partnership is made up of two or more persons carrying on a business for profit. This business structure usually has a partnership agreement, but the agreement does not have to be in writing and there is no state filing requirement.[3]

Limited Partnership (“LP”): A Texas 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 business structure is formed by a partnership agreement, which can be written or oral. While the partnership agreement is not filed for public record, the limited partnership must file a certificate of formation with the Texas Secretary of State.[4]

Limited Liability Partnership ("LLP”): General or limited partnerships can register with the Texas Secretary of State as an LLP to limit the liability of their general partners.[5]

How are Partnerships taxed?

Partnerships are pass-through entities (similar to sole proprietorships), so profits and losses from the business are passed through to the partners of the business and filed on the partners’ personal tax returns (Schedule E). Additionally, in order to report pass-through profits and losses, partnerships generally need to file a separate business tax return (Form 1065).[6]

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Corporations

A Texas corporation is created by filing a certificate of formation with the Texas Secretary of State. It is a business structure that has limited liability, centralization of management, perpetual duration, and transferability of ownership interests. The owners are called shareholders, and the managers of the corporation are called directors. Under state corporate law, shareholders can enter into a shareholders’ agreement to eliminate the directors and allow the shareholders to manage the corporation.[7]

How are Corporations taxed?

1.     C Corporation (“C Corps”): C Corps are not pass-through entities. They generally file corporate tax returns (Form 1120) every year and are taxed on their profits. If any profits are distributed to shareholders in the form of dividends, the shareholders are taxed individually. This is called double taxation.[8]

2.     S Corporation (“S Corps”): S Corps are treated as pass-through entities, and profits/losses are taxed at the shareholder level based on the ownership percentage of each shareholder. Additionally, the S Corp generally must file an annual business tax return (Form 1120-S).[9] However, in order to be taxed as an S Corporation, the corporation must file Form 2553.[10]

Limited Liability Company (LLC)

A Texas limited liability company is created by filing a certificate of formation with the Texas Secretary of State. It is not a partnership or corporation, but it has powers of both corporations and partnerships. It can be modeled after a general partnership with limited liability, after a limited partnership where all owners can participate in management and all have limited liability, or after an S Corp without the tax and ownership restrictions under the Internal Revenue Code.[11]

The owners are called “members”; members can be individuals, partnerships, corporations, trusts, etc. The members' liability is limited to their investment, and they can benefit from the pass-through tax treatment available to partners in a partnership.[12]

How are LLCs taxed?

If an LLC only has one member, it is automatically considered a disregarded entity by the IRS. The IRS disregards it for federal income tax purposes; the owner pays the entity’s portion of the taxes on his own individual income tax return.[13] If an LLC has at least two members, it is classified as a partnership for federal income tax purposes. However, an LLC (and other entity types) may file Form 8832 and elect to be treated as a different type of taxable entity (e.g., S Corp) for federal income tax purposes.[14] After an LLC files Form 8832, it can then file Form 2553 to be treated as an S Corp for federal tax purposes.[15]

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Conclusion

While Texas has many business structure options, it is important for taxpayers who want to form a business to look at the qualifications for the business structure they desire, as well as the way it will be taxed by the IRS. Choosing the right structure is imperative to have the best liability protection and tax savings.

If you would like more information on choosing the right business entity for your business, check out How to Choose the Right Business Entity for Your Business.

Contact Montgomery Legal today to discuss your case and legal options. Schedule a Consultation or call (214) 432-6100.

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[1]Selecting a Business Structure, Texas Secretary of State, available at https://www.sos.state.tx.us/corp/businessstructure.shtml.

[2] Greg Daugherty, Tax Implications of Business Structures, Investopedia (January 2024), available at https://www.investopedia.com/articles/personal-finance/120915/which-type-organization-best-your-business.asp.

[3] See Selecting a Business Structure, supra note 1.

[4] Id.

[5] Id.

[6] See Daugherty, supra note 2.

[7] See Selecting a Business Structure, supra note 1.

[8] See Daugherty, supra note 2.

[9] Id.

[10] S Corporations, available at https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations#:~:text=In%20order%20to%20become%20an,signed%20by%20all%20the%20shareholders.

[11] See Selecting a Business Structure, supra note 1.

[12] Id.

[13] Christine Organ, What is a Disregarded Entity, Forbes Advisor (December 12, 2022), available at https://www.forbes.com/advisor/business/what-is-disregarded-entity/.

[14] Limited Liability Company (LLC), available at https://www.irs.gov/businesses/small-businesses-self-employed/limited-liability-company-llc#:~:text=Specifically%2C%20a%20domestic%20LLC%20with,be%20treated%20as%20a%20corporation.

[15] Nelson, LLC electing S Corp tax status: An option you may not know you have, Wolters Kluwer (February 12, 2023), available at https://www.wolterskluwer.com/en/expert-insights/llc-electing-s-corp-tax-status-an-option-you-may-not-know-you-have#:~:text=of%20the%20Code.-,LLC%20taxed%20as%20an%20S%20corporation,treatment%20as%20an%20S%20corporation.

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