Every business should have an organizational structure; a formal arrangement of managerial hierarchies within a company that determines the reporting relationships and the informational flows. This arrangement is the basis for operational policies and shapes culture.
The structure your business started out with may no longer be adequate or appropriate due to business growth, the need for liability protection, or to pursue outside investors. The steps for changing from one structure to another are not difficult, in the main but do involve legal activity. The change can also have substantial tax implications.
TYPES OF BUSINESS STRUCTURES RECOGNIZED BY THE STATE OF TEXAS
SOLE PROPRIETOR
Sole Proprietor is a one-person business run for profit. The only requirement the state of Texas has towards a sole proprietor is if the business will be run under another name than that of the individual owner. In that case, you are required to file a “Doing Business As” or DBA document with the office of the Country Clerk in the county where the business will operate or be maintained.
One disadvantage to Sole Proprietor is that you have no personal liability protection and could be sued for your personal assets.
GENERAL PARTNERSHIP
A General Partnership is similar to a Sole Proprietor except more than one person is involved. Two or more people have formed a partnership to make a profit. Each person involved is called a general partner. If the business runs under a name that does not include one or more of the partners' surnames, you must file a DBA with the County Clerk’s Office.
A general partnership is not the best way go into business unless you have a formal partnership agreement that outlines all the rules of being in business together. Otherwise, the state will do it for you and the Texas Business Organizations Code (BOC) will decide the rights and privileges of the partners. There is no liability protection with this structure, either.
LIMITED PARTNERSHIP
A Limited Partnership is more complex than a general partnership but has the liability protection a general partnership does not offer. You must file a certificate of formation; then the entity is created. However, until a partnership agreement has been filed, the Texas BOC dictates operations and governance.
A limited partnership can have general partners and limited partners. General partners control the operations and are responsible for the debt and obligations of any limited partnerships. However, the general partners have no liability protection under Texas law.
Limited partners do have liability protection from debts and obligations of the limited partnership but are not allowed to participate in operations nor as agents. Limited partners are sometimes called “silent investors.” They are only there to provide financial funding for the business.
CORPORATIONS
Corporations are businesses that are considered a separate entity from the owners and has limited:
- liability
- centralized management
- perpetual duration
- easy transfer of ownership interests
A corporation can sue and be sued, it can hold property in its name, and it pays taxes separately from the owners.
Owners are known as shareholders, and each owns a percentage of the business calculated by the number of shares held divided by total shares available. The management structure is much more complex than the structures previously discussed and often has a Board of Directors to govern major operations and executive officers to run the daily operation.
The biggest disadvantage of a corporation is the problem of "double taxation." Shareholders pay taxes on earnings before they can be passed to the shareholder as dividends, then the shareholder must pay tax on the dividends received. Becoming an S-corporation eliminates this problem, but only US citizens can be shareholders in an S-corporation.
LIMITED LIABILITY COMPANY
A Limited Liability Company, or LLC, is also recognized by the state as a separate legal entity. It is created by filing a certificate of formation with the Texas Secretary of State, but the management structure must be stated in the certificate.
An LLC is owned by members rather than shareholders. Members can be individuals, partnerships, corporations, trusts, or other legal or commercial entities. The reason it is called a limited liability company is that the liability protection for personal assets is limited to the member’s investment. In return, the member gets pass-through tax treatment in which there is no double-taxation. Non-citizens can be members of an LLC.
LLCs are very flexible under Texas law and can be created to meet the particular needs of it owner(s). The rigid requirements of a corporation are mitigated.
CHANGING ORGANIZATIONAL STRUCTURE
Perhaps your business has outgrown the structure it started with, and it's time to make a change. Alternatively, maybe the business needs to simplify its organization. In either case, you would be smart to involve employees from all levels of the business in planning the change. Keep communication open and clear, and use positive language, especially if layoffs may be necessary.
- Look at the options first. The business structure you use determines how much regulatory documentation is required, how much personal liability you have for business decisions, and how you are taxed on business income. Become familiar with each structure using these criteria before making a decision whether to change and which structure should be the replacement.
- Expect changes according to the type of structure you decide you require for your current business needs.
- Sole Proprietor or General Partnership to LLC or Corporation: you and your partner(s) will move from unlimited personal liability to limited liability. You will have more paperwork to file, and you will see increased fees and expenses.
- LLC or Corporation to Sole Proprietor or General Partnership: it is more difficult to make this change. You will need to get agreement from the corporation shareholders to liquidate business assets. If you are moving from an LLC, you will only experience changes in your tax obligations. You're required to notify the IRS and adhere to specific state policies such as licensing.
- Communicate clearly and often to everyone involved with the business to keep it top of mind until implementation. Thoroughly explain why you are doing this and roll out changes one department at a time so you can correct logistical issues as soon as possible. If layoffs are part of the plan, consult an attorney before doing so and try to find new positions for employees before letting them go.
- Notify your bank and insurance company since you may be required to transfer assets. You may need to file a new DBS and/or a new EIN. Let state and local agencies know of the change as well as your suppliers and customers.
Changing the organizational structure of a business is not unusual. Through business growth or changes in leadership, it may become apparent that the current structure no longer serves your business needs.
Carefully assess the pros and cons of each business structure including the amount of liability protection you need and how you want to manage operations and set policy. Once your decision is made, keep everyone who is impacted by the change in the loop to streamline implementation and retain the trust of the other members.