Organizational Filings
Note: The commentary in this chapter addresses filing and formation issues specific to limited liability companies. For information on business entity formation and organizational filing requirements generally, see the commentary in chapter 1 of this manual.
§ 21.1Limited Liability Companies
§ 21.1:1Limited Liability Company in General
Corporations are good choices for providing liability protection for investors, but that protection comes at a high cost, namely tremendous organizational formalities and “double taxation,” discussed at section 21.2 below. A limited liability company (LLC) is an entity that offers liability protection to its owners similar to a corporation while allowing owners to avoid some of the legal formalities and tax rules that apply to corporations. It is neither a corporation nor a partnership but has attributes of both. It is one of the most flexible and efficient ways to structure an entity.
The owners of the LLC are “members” who share equally in the company’s profits and losses unless otherwise agreed to by the members. See Tex. Bus. Orgs. Code §§ 101.052(c), 101.101–.104, 101.201. Members may be individuals, partnerships, corporations, or any other legal entity. See Tex. Bus. Orgs. Code §§ 1.002(69–b), 101.102(a). Limited liability companies may have any number of members. See Tex. Bus. Orgs. Code § 101.101(a). In a member-managed LLC, all members are responsible for managing the business. See Tex. Bus. Orgs. Code § 101.251(2). In a manager-
managed LLC, the business is managed by managers who may be, but are not required to be, members of the LLC. See Tex. Bus. Orgs. Code §§ 101.251(1), 101.302.
To form an LLC, a certificate of formation must be filed with the Texas Secretary of State. The company must have a company agreement if the members do not wish to subject themselves to statutory default provisions. See Tex. Bus. Orgs. Code §§ 3.001, 101.052. A company agreement has the added benefit of providing protection against an argument that the LLC was the alter ego of its members in a veil-piercing claim by showing that the members maintained the separate existence of the entity. See Doyle v. Kontemporary Builders, Inc., 370 S.W.3d 448, 458 (Tex. App.—Dallas 2012, pet. denied). The certificate of formation has minimal requirements and can be drafted from scratch or completed using secretary of state Form 205 (form 21-1 in this chapter). The filing fee for a certificate of formation is $300 plus a 2.7 percent fee for payments made by credit card. Current filing fees are listed at the secretary of state’s SOSDirect website, https://direct.sos.state.tx.us.
The certificate of formation must state the name of the LLC, which must include the phrase “limited liability company,” “limited company,” or an abbreviation of one of those phrases. Tex. Bus. Orgs. Code § 5.056. The name of a filing entity or the name under which a foreign filing entity registers to transact business in Texas must also be distinguishable in the records of the secretary of state from the name of another existing filing entity or an entity name that is reserved or registered with the secretary. See Tex. Bus. Orgs. Code § 5.053(a). See section 1.1:2 in this manual for more information on entity name availability.
The certificate of formation must state the street address of the initial registered office of the LLC and the name of the registered agent. Tex. Bus. Orgs. Code § 3.005(a)(5). The registered agent can be an entity registered to do business in Texas or an individual who resides in the state. The person or entity designated as registered agent must give consent to be the registered agent. Tex. Bus. Orgs. Code § 5.201(b). The best practice is to maintain a copy of the agent’s written consent in the LLC records. Secretary of State Form 401-A (form 1-2 in this manual) may be used to document a registered agent’s acceptance of appointment. An LLC cannot act as its own registered agent. See Tex. Bus. Orgs. Code § 5.201.
The certificate of formation must also state the name and physical address of each organizer. Tex. Bus. Orgs. Code § 3.005(a)(6). Unless the entity is formed under a plan of conversion or merger, at least one organizer is required, who must be a natural person eighteen years of age or older or a legal entity. See Tex. Bus. Orgs. Code §§ 1.002(69–b), 3.004(a), 3.005(a)(6)(A).
The certificate of formation must state whether the company will be manager-managed or member-managed. If the LLC will have managers, the company must provide the names and addresses of each initial manager. If the LLC will not have managers, the company must provide the names and addresses of each initial member. Tex. Bus. Orgs. Code § 3.010.
The certificate of formation must state the purpose for which the LLC is formed, which may be or include any lawful purpose for that type of entity. Tex. Bus. Orgs. Code § 3.005(a)(3).
Texas LLCs exist in perpetuity unless declared otherwise on the certificate of formation. See Tex. Bus. Orgs. Code § 3.005(a)(4).
A certificate of formation becomes effective when filed with the secretary of state; however, organizers may choose to delay the effective date by up to ninety days from the date signed by stating the later date on the certificate. See Tex. Bus. Orgs. Code §§ 4.051–.053.
Entity owners should consult tax counsel for advice concerning the advantages and disadvantages of the various tax elections to be made when forming an LLC. A thorough understanding of how the LLC will be taxed will help in properly drafting the company agreement.
Single-member LLCs are, by default, “pass-through” or “disregarded” entities for federal tax purposes. Although the Internal Revenue Service treats most entities, such as corporations, as distinct from their owners, the IRS does not consider a pass-through entity to be separate from the business owner. Treas. Reg.
§ 301.7701–2(c)(2)(i). All of the LLC’s net income is considered the member’s self-employment income and is reported on schedule C of the member’s personal income tax return. See Treas. Reg. § 301.7701–2(c)(2)(iv)(D)(iii).
Multimember LLCs are taxed as partnerships unless they elect otherwise. See 26 U.S.C. § 1362(a). A multimember LLC must file an annual information return with the IRS and furnish its members with a copy of the schedule K from that return, along with the member’s individual schedule K-1. 26 U.S.C. § 6031. See also Treas. Reg. § 301.6722–1(d)(2)(i).
An LLC can elect out of its default tax structure by choosing to be taxed as a corporation. An LLC can elect to be one of two types of corporation: a C corporation or an S corporation. See 26 U.S.C. § 1362(a); Treas. Reg. § 301.7701–3(a).
If an LLC opts to be taxed as a C corporation, it will pay federal income tax as an entity on the net taxable income, and all distributions to its members are treated as dividends, which are further taxed at the individual member’s federal income tax rate. 26 U.S.C. §§ 11, 301. Taxation of both corporate income and of the dividends paid to members is sometimes referred to as “double taxation.” Historically, LLCs have not opted for this option because the highest corporate tax rate was 35 percent, but with the recent lowering of the rate to 21 percent, this may become more common. See Tax Cuts and Jobs Act of 2017, Pub. L. No. 115-97, § 13001, 131 Stat. 2054 (2017), 26 U.S.C. § 11. Dividends that are the result of a corporation’s long-term capital gains may be considered “qualified dividends,” which may be taxed at lower rates than the individual’s tax bracket. See 26 U.S.C. § 1(h)(11).
An LLC may also opt to be taxed as an S corporation if certain requirements are met. 26 U.S.C. § 1362(a). The main requirements are that the LLC cannot have more than one hundred members, who must all be U.S. citizens. Also, the election requires the consent of each member and, for each member residing in a community-property state, the consent of the member’s spouse. 26 U.S.C. §§ 1361(a), (b), 1362(a); Treas. Reg. § 1.1362–6(b)(2)(i). An S corporation election may offer distinct tax advantages, particularly with respect to self-employment tax, as the LLC is still treated as a pass-through entity. See 26 U.S.C. § 1363. The client should consult an accountant or tax attorney before making any election. Additionally, the client should get tax advice before setting salaries for entity members to ensure that the salaries are reasonable in relation to the services provided. See 26 U.S.C. § 707(a).
Texas LLCs are subject to the state franchise tax. See section 1.9 in this manual for more in-formation about the Texas franchise tax.
Entities taxed as partnerships, including multimember LLCs that make such an election, are subject to the Bipartisan Budget Act of 2015 § 1101 (amended 2018), 26 U.S.C. §§ 6221–6241 (“BBA”), which drastically changes audit and collection procedures for tax years beginning after December 31, 2017.
The BBA creates a new centralized regime, wherein the IRS audits and collects underpayments due from a partnership at the entity level instead of the partner (personal) level. This change shifts liability for underpaid taxes, interest, and penalties resulting from an audit from the partners who were in the partnership during the tax year in which the underpayments relate (the audited or “reviewed year”) to the partners in the tax year in which the adjustments become final (the “adjustment year”). See 26 U.S.C. § 6225(a), (d). It is possible that the partners in the adjustment year are not the same as, or do not have the same percentage interests as, the partners in the reviewed year. This shift in liability may result in potential conflicts between partners, including a desire by adjustment-year partners to seek reimbursement from reviewed-year partners.
The BBA replaces the tax matters partner, a position formed by the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”), with a “partnership representative.” See 26 U.S.C. § 6223(a). It is not at all clear yet whether the IRS or courts will find that a partnership’s tax matters partner can function as its partnership representative. Thus, entities in existence before January 1, 2018, should (1) retain or include language designating a tax matters partner in their operating agreements until the statute of limitations for audits expires for those tax years governed by TEFRA, limiting the tax matters partner’s authority to tax years ending before January 1, 2018; and (2) appoint a partnership representative for tax years beginning on or after January 1, 2018. Unlike a tax matters partner, a partnership representative can be anyone, including a sole individual or entity, and does not have to be a partner or member of the company. See 26 U.S.C. § 6223(a).
§ 21.2:2Opting Out of New Audit Regime
Partnerships and multimember LLCs taxed as partnerships may opt out of the new audit regime and elect to be governed by the previous audit rules in a number of ways, including the following.
Election-Out: Partnerships that furnish no more than one hundred schedule K-1s for their partners are eligible to opt out of the new default audit rules if all the partners are eligible partners at all times during the taxable year and are individuals, domestic C corporations, certain foreign entities, deceased partners’ estates, or S corporations. 26 U.S.C. § 6221(b)(1). A partnership is not eligible to elect out under section 6221 if any of its partners is a partnership, dis-regarded LLC, trust, foreign entity that would not be treated as a C corporation if it were domestic, estate of a nonpartner deceased individual, or person holding the partnership interest on behalf of another person. Treas. Reg. § 301.6221(b)–1(b)(3)(ii). Schedule K-1s issued by a partner that is an S corporation to its shareholders are counted for purposes of determining whether a partnership has furnished no more than one hundred schedule K-1s. 26 U.S.C. § 6221(b)(2). The partnership must make the election on a timely filed return each taxable year and notify the partners of the election. The return must also include information about the partners, such as names and taxpayer identification numbers. 26 U.S.C. § 6221(b)(1), (2).
The partnership agreement may contain provisions that (1) make this election mandatory, if qualified under the statute, and (2) prohibit the partnership or partners from allowing the transfer of partnership interests or taking any other actions that would disqualify the partnership from making the election.
Push-Out Election: When a partnership receives a notice of final partnership adjustment, the partnership has forty-five days from the issuance of the notice to elect to push out the imputed underpayment to the reviewed-year partners by furnishing them an adjustment statement, similar to a schedule K-1. This election generally benefits partners in the adjustment year at the expense of partners from the reviewed year. The IRS may not permit the push-out election for tiered partnerships. 26 U.S.C. § 6226(a).
Again, the partnership agreement may include provisions that (1) require the partnership to make this election on a timely basis and in all audit situations and (2) prohibit the partnership or partners from taking any actions that would disqualify the partnership from making the election.
Tax Indemnification Provisions: Partnership agreements, partnership share purchase agreements, or other internal agreements can include tax indemnification provisions that allocate any liabilities arising from imputed underpayments according to the partners’ interests in the re-viewed year. Indemnification provisions should also provide that the indemnification is mandatory, rather than being subject to a partnership election or other decision. Agreements for the purchase of partnership interests by new partners from existing partners should include tax indemnity provisions to cover adjustments under the BBA audit regime. Note that any allocations resulting from these tax indemnity provisions must have substantial economic effect for the IRS to allow the agreement to ultimately control in the determination of the partners’ distributive shares. See 26 U.S.C. § 704(b); Treas. Reg. § 1.704–1(b)(2).
See form 22-4 in this manual for optional provisions relating to partnership representatives and audit procedures to include in LLC agreements.
§ 21.2:3Partnership Representative
The partnership representative is the sole authority who can act on behalf of the partnership in relation to the IRS, with the ability to bind both the partnership and the partners in administrative or judicial proceedings. Partners do not have the ability to appeal or challenge the decisions of the partnership representative. LLCs may want to include procedures in their operating agreements for preapproving decisions of the partnership representative made in connection with an audit and establish requirements for the partnership representative and members to provide information to each other on a timely basis. These limitations are not binding on the IRS but provide contractual protections to the partners.
If the LLC does not designate a partnership representative, the secretary of the treasury may designate any person to fill the role. See 26 U.S.C. § 6223(a). If for no other reason than simply to avoid this default provision, all LLC operating agreements should include provisions to require the LLC to designate the required partnership representative and to immediately replace the representative should the position become vacant.
See form 22-4 in this manual for optional provisions relating to partnership representatives and audit procedures to include in LLC agreements.
A series LLC is an LLC that provides in its governing documents for the establishment of a series of members, managers, membership interests, or assets that have separate rights, obligations, and liabilities and business purposes from the general (“master”) LLC. Each individual series has the ability to sue and be sued, enter into contracts, hold title to assets, and grant liens or security interests in its assets; however, the individual series is not a separate domestic entity or organization. See Tex. Bus. Orgs. Code §§ 101.602(c), 101.605, 101.622. A series may also be a promoter, organizer, partner, owner, member, associate, or manager of an organization. Tex. Bus. Orgs. Code § 101.605(5). The provisions governing a domestic series LLC are in Tex. Bus. Orgs. Code §§ 101.601–.622.
The series of an LLC may be established in the company agreement. See Tex. Bus. Orgs. Code § 101.601. However, the debts, liabilities, obligations, and expenses of a series are enforceable against the LLC generally and against other series (and not just the subject series) unless the requirements of Tex. Bus. Orgs. Code § 101.602 are met. Therefore, to receive the full benefits of a series LLC regarding limitation of liability, separate records for the assets of each series must be maintained, the company agreement must contain a statement to the effect of the limitations provided by Business Organizations Code section 101.602(a), and the LLC’s certificate of formation must include a notice of the limitations provided by section 101.602(a). See Tex. Bus. Orgs. Code § 101.602(b).
The computer records of the secretary of state do not categorize or identify those LLCs that are authorized to establish series. Consequently, the only means of determining whether a particular LLC is authorized to establish a series is to review its company agreement and certificate of formation or any amendment to its certificate of formation for the notice of limitations required.
The notice of limitations does not need to make reference to a specific series. The notice contained in the certificate of formation of a series LLC must state that—
1.the debts, liabilities, obligations, and expenses incurred, contracted for, or otherwise existing with respect to a particular series shall be enforceable against the assets of that series only and shall not be enforceable against the assets of the LLC generally or any other series; and
2.none of the debts, liabilities, obligations, and expenses incurred, contracted for, or otherwise existing with respect to the LLC generally, or any other series, shall be enforceable against the assets of a particular series.
Tex. Bus. Orgs. Code § 101.602.
PRACTICE TIP: The authorization to establish a series is an optional provision that would be included in the certificate of formation. Because the notice is not required for formation of the LLC, the secretary of state does not review the notice of limitations to determine whether the notice complies with Business Organizations Code section 101.602(a) or review the sufficiency of any language establishing a series. This means that the secretary of state will not reject a certificate of formation for correction if such language is missing, even when it appears that the submitting party might have intended to form a series LLC.
The secretary of state does not have a “form” for a domestic series LLC. If the practitioner decides to use the secretary of state’s general LLC form (SOS Form 205, form 21-1 in this chapter) to form a series LLC, the language suggested in form 21-7 may be included in the “Supplemental Provisions/Information” section.
No further notice or filing is required when the LLC establishes a series. Nevertheless, the secretary of state will not reject a certificate of amendment that amends the certificate of formation of a series LLC to add provisions that relate to the establishment of specific series. However, as noted above, the secretary of state records will not reflect how many series have been established by a series LLC or whether the LLC has established a series under a particular name.
The name of a series established by a series LLC is an assumed name of the LLC. See Tex. Bus. & Com. Code § 71.002(2). The master or parent LLC would file an assumed name certificate with the secretary of state and with the appropriate county clerk in compliance with chapter 71 of the Texas Business and Commerce Code.
PRACTICE TIP: When completing SOS Form 503 (form 21-6 in this chapter), enter only the legal name of the master/parent LLC in item 2 of the form; do not include the name of the individual series. Inclusion of an individual series name (e.g., “Master Development, LLC Series A”) as the entity name of the assumed name registrant will result in a rejection of the assumed name certificate. If you want to include the name of the individual series associated with the assumed name within the assumed name certificate, you may draft your own assumed name certificate form and include that information in a separate numbered paragraph.
Only a small minority of states authorize a series LLC; consequently, a person forming a series LLC should contact the filing office and tax office in the state in which the LLC contemplates transacting business to determine how the jurisdiction treats series LLCs for purposes of registration and taxation.
Titles 2 and 3 of the Texas Business Organizations Code do not restrict the purpose of an LLC to the rendition of a for-profit business, trade, or profession. Before the Business Organizations Code went into effect, it was the secretary of state’s position that the formation of a nonprofit LLC was inconsistent with the provisions of the Texas Limited Liability Company Act (repealed) and the laws made applicable to an LLC—namely, the Texas Business Corporations Act (repealed) and the Texas Revised Limited Partnership Act (repealed). Because the Business Organizations Code does not restrict the purpose, an LLC may be formed to engage in a nonprofit purpose. Other state law regulating a particular activity may contain restrictions that would prohibit an LLC from engaging in the regulated activity.
An LLC may be organized solely for one or more nonprofit purposes specified by Business Organizations Code section 2.002. Nonprofit purposes include—
1.operating or managing professional, commercial, or trade associations;
2.serving charitable, benevolent, religious, fraternal, social, educational, athletic, patriotic, and civic purposes; and
3.operating on a nonprofit cooperative basis for the benefit of its neighbors.
See Tex. Bus. Orgs. Code § 2.002.
An LLC with a nonprofit purpose is distinct from a nonprofit corporation or other nonprofit association. See Tex. Bus. Orgs. Code § 1.002(58), (59). A Business Organizations Code provision that applies specifically to a nonprofit corporation does not apply to an LLC formed for a nonprofit purpose. See Tex. Bus. Orgs. Code § 1.002(58)–(60). For example, the default tax-exempt provisions found in Business Organizations Code section 2.107 apply to a nonprofit corporation but do not apply to a nonprofit LLC.
There is no statutory basis for distinguishing between an LLC formed for a for-profit purpose and an LLC formed for a nonprofit purpose. Filing fees established under Business Organizations Code sections 4.151 and 4.154 apply to all LLCs regardless of purpose.
Section 171.088 of the Texas Tax Code permits an entity that is not a corporation to qualify for a tax-exempt status if its activities would qualify it for a specific tax exemption were the entity formed as a corporation. See Tex. Tax Code § 171.088.
PRACTICE TIP: Many Texas secretary of state forms common to corporations and LLCs are located in chapter 1 of this manual.