A Texas corporation can only be created by filing articles of incorporation with the Texas Secretary of State.
A corporation does provide limited liability for its shareholders such that shareholders’ liability is limited to each shareholder’s interest in the corporation. Consequently, the recovery of a judgment creditor of a corporation is limited to the assets of the corporation. In other words, the corporation is responsible for its own debts and torts, not the shareholders. The individual assets of the shareholders may not be used to satisfy the judgment creditor of a corporation, provided the corporate structure is respected by the shareholders and the courts. While the limited liability protection a corporation offers to its shareholders is a fundamental attribute of the corporate form, three important exceptions exist.
No Business Asset Protection
First, an often ignored drawback of the corporate form involves business asset protection. Business asset protection is the protection of business assets from the individual liabilities of the business owners. Liability protection does not extend to the assets of the corporation, as the shares owned by a shareholder may be attached by a judgment creditor of a shareholder. If the shareholder owned a controlling interest in the corporation and the judgment creditor satisfied the judgement with the controlling shares of the corporation, the judgment creditor of the individual shareholder could gain control of the business. The creditor could then ultimately run the corporation and sell off all the corporation’s assets to satisfy the judgment.
Piercing the Corporate Veil
Second, another exception to the doctrine that the corporate form will protect shareholders from the liabilities of the corporation involves piercing the corporate veil. Piercing the corporate veil, or disregarding the corporate entity, refers to the judicially imposed exception to the principle of limited liability by which courts disregard the separateness of the corporation and hold a shareholder responsible for the corporation’s action as if it were the shareholder’s own. Texas courts distinguish between claims arising from tortuous actions and claims arising out of a contract. If the claim involves a tort, the plaintiff need not show that the corporation acted in a fraudulent manner. However, if the claim involves a contract dispute, the plaintiff’s burden of proof is elevated because the plaintiff must show actual fraud. The theory behind this distinction arises from the belief that in a tort case, the relationship with the corporation is involuntary; and in the case of a contract, the relationship with the corporation is voluntary. The courts in Texas have disregarded the corporate form under the following theories:
- the corporation form is used as a means to perpetrate fraud;
- the corporation is organized and operated as a mere tool or business conduit of another corporation;
- the corporate form is used to evade an existing legal obligation;
- the corporate form is used to perpetrate monopoly;
- the corporate form is used to circumvent statute; and
- the corporate form is used to justify wrongdoing.
In order for the corporate structure to be respected by the courts and prevent the corporate veil from being pierced, the shareholders should observe corporate formalities. Specifically, the corporation should, among other things:
- keep the minute book up to date by including minutes of annual and special meetings;
- maintain financial records separately from the individual shareholders;
- issue stock certificates;
- adhere to the bylaws;
- maintain the stock ledger;
- hold directors meetings to approve large expenditures, long-term leases, and compensation plans;
- insure that the corporation is adequately capitalized and insured; and
- avoid transactions involving self-dealing.
All corporations are subject to franchise tax in Texas. A corporation must pay 1% of gross receipts over $1,000,000; 0.5% for wholesalers and retailers; 0.575% for businesses with $10 million or less in annual revenue and filing E-Z Computation form. Under federal law, a corporation may be taxed as a corporation under Subchapter C of the Internal Revenue Code or as a pass through entity under Subchapter S of the Internal Revenue Code.
Unless the corporation elects otherwise, it will be taxed under Subchapter C of the Internal Revenue Code. Consequently, the net income of the corporation will be subject to income tax at the corporate level. If the net income is distributed to shareholders and not added to the retained earnings of the corporation, the shareholders must pay income tax on the dividend, resulting in what many practitioners refer to as “double taxation.” Some individuals get around this double taxation issue by taking the net income out of the corporate entity as wages. These wages are a deduction to the corporation and income to the shareholder employee.
If a corporation makes an election with the IRS on Form 2553 to be taxed as a Subchapter S corporation, then the corporation will be taxed as a flow through entity. The Form 2553 must be filed: 1) at any time on or before the 15th day of the third month of the tax year; or 2) at any time during the preceding tax year. A corporation must have the following characteristics in order to qualify for Subchapter S tax treatment:
- it is a domestic corporation;
- it has no more than 75 shareholders;
- the shareholders are individuals, estates, certain exempt organizations, or qualified subchapter S trusts;
no nonresident aliens are shareholders;
- it has only one class of stock; and
- it has a tax year ending December 31, unless electing otherwise.
The taxation regime outlined in subchapter S of the Internal Revenue Code allows flow through taxation so that the net profits of the corporation flow straight to the shareholder’s individual income tax return instead of being first taxed at the corporate level. Generally, the S corporation enables shareholders to receive a reasonable salary and then take the remaining profits as net income subject only to income tax, not social security and medicare taxes. However, the benefits associated with taking the profits out of the S corporation without those profits being subject to social security and medicare taxes must be balanced against the franchise tax.
The C corporation is frequently used by business owners seeking venture capital, planning to go public, anticipating much growth, seeking to increase the value of the business, and/or requiring the maintenance of a large capital base by the corporation (for research and development, as an example). Small businesses often operate as S corporations.
Other Types of Corporations
The professional corporation is formed by filing articles of incorporation with the Texas Secretary of State and setting out inside the articles that the corporation is a professional corporation. The professional corporation may be taxed as either a C corporation or an S corporation and is subject to franchise tax in Texas. Business owners may form professional corporations if they are professional service providers such as attorneys, architects, CPAs, etc. The professional corporation does not offer limited liability protection for the professional malpractice of the shareholder. However, the business owner enjoys limited liability for claims accruing from sources other than the business owner’s own activity. For example, if a client of the business owner suffers injury from a fall in the business owner’s office, the business owner will be shielded from personal liability, so long as the fall did not result from the business owner’s own negligence.
The professional association is formed by filing articles of association with the Texas Secretary of State. The professional association may be taxed as either a C corporation or an S corporation. The professional association is subject to franchise tax in Texas. The types of individuals that can form a professional association are only those persons duly licensed to practice a profession, including: podiatry, dentistry, optometry or therapeutic optometry, or chiropractic medicine. Again, this type of entity does not offer limited liability protection for the professional malpractice of the shareholder. However, like the professional corporation, the business owner enjoys limited liability for claims accruing from sources other than the business owner’s own activity.
The nonprofit corporation is formed by filing articles of incorporation for a Texas nonprofit corporation with the Texas Secretary of State. If the nonprofit seeks to be exempt from state and federal taxation, the corporation must file a Form 1023 Application for Recognition of Exemption with the IRS. If the application is approved, then the nonprofit will receive a determination letter or advanced ruling from the IRS. If the nonprofit seeks tax exempt status with the State of Texas, the nonprofit must file a statement of activities with the Texas Comptroller of Public Accounts and enclose the determination letter or advanced ruling received by the IRS. Upon formation, all the officers and directors of a nonprofit enjoy limited liability so long as their actions do not constitute a breach of the fiduciary duty of loyalty to the nonprofit corporation. Generally, as long as the nonprofit corporation receives tax exempt status from the IRS, it is not subject to federal income tax and so long as the nonprofit corporation receives tax exempt status
from the Texas Comptroller of Public Accounts it is not subject to sales or franchise tax. Three important exceptions exist to this rule. First, unrelated business income, which is income received that is not in furtherance of the nonprofit’s tax exempt purpose, is subject to income tax. Second, the nonprofit must pay employment taxes. Third, the nonprofit must also pay property tax unless the real property is used in furtherance of its exempt purpose. Additionally, if a nonprofit’s gross receipts total more than $25,000 and it is not a church or other organization exempt from filing, then the nonprofit is required to file annual returns with the IRS. Such filings are done on Form 990.