Too Small to Incorporate in Texas

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Not long ago, I received an interesting email query from a University of Texas MBA student. The MBA student wanted to know if he should incorporate a part-time consulting business he had started, given its small scale.

While his question is one that people from any state can ask, the nuances of Texas corporation and limited liability company formation and taxation slightly complicate the answer for Texas small businesses. As a result, potential entrepreneurs need to carefully consider three factors:

Factor #1 - Initial Expenses of Incorporating

A first thing to think about when contemplating incorporating in Texas is the initial cost of incorporation.

The good news here is that incorporation represents a pretty good bargain.

The fee to file the articles of incorporation (also known in Texas as a "certificate of formation for a for-profit corporation) or the articles of limited liability company formation run $300. Note that you can pay the fee by check, money orders, or credit card, but if you pay by credit card, the state dings you an extra 2.7% credit card convenience fee.

While three hundred bucks isn't that much in one sense, $300 is significant enough to discourage some very small firms from incorporating. Any business with only a few thousand dollars of revenue a year, for example, probably can't justify paying to incorporate. (Such firms may want to wait until they grow larger.)

Note: You absolutely can file your articles of incorporation yourself, but if you need help from a lawyer or CPA your costs rise.

Factor #2 - On-going Accounting Costs of Incorporation and LLC Status

Another factor to consider when you're talking about setting up a corporation or limited liability company for a small Texas business are the on-going accounting costs of running the venture as a corporation or LLC.

And here, unfortunately, one encounters some bad news--at least for the incorporation option. If you run your business as a corporation (including as an S corporation), your business owes a corporate tax return. And that corporate tax return will require you to pay several hundred dollars to some small business accountant for tax return preparation.

Note: You can buy do-it-yourself tax preparation software that lets you prepare a corporation return. But a corporation is much more involved than an individual tax return. Accordingly, while many accountants will recommend people file their own individual tax returns using, for example, do-it-yourself tax software, few accountants will recommend people file their own business tax returns using such software.

By the way, the really interesting thing about a small limited liability company is that if the LLC is owned by a single person or if the LLC is owned by husband and wife, the LLC's income and deductions can be reported on the owner's (or the husband-and-wife owners') tax return. That means the LLC doesn't need its own (expensive) tax return.

For many micro-businesses, obviously, the limited liability company option is attractive.

Note: In a community property state like Texas, an LLC owned by a husband and wife may also show the entity's income and deductions on their joint 1040 tax return.

Factor #3 - State Franchise Fees

A final factor to ponder when incorporating in Texas is the state's franchise tax.

Corporations and S corporations pay the greater of a 0.25% tax on "net taxable capital" or a 4.5% tax on something called "net taxable earned surplus."

Limited liability companies pay only the 0.25% tax on net taxable capital.

The net taxable capital for a corporation or LLC basically equals the business's net worth. And the surplus earnings combine the corporation's net taxable income and the compensation paid to officers and directors (but only when the corporation's shareholders number more than thirty-six).

In summary, then, a Texas LLC may pay an annual franchise tax equal to roughly .25% of the LLC's capital. And a corporation (including an S corporation) will either pay the .25% fee or a 4.5% tax on profits.

The Texas franchise taxes, then, should cause entrepreneurs to favor the LLC alternative unless the small businesses gets other federal-level tax savings from being treated as a corporation.

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