Protecting business interests under Texas law is one of the main parts of my practice. Are you a sole proprietor? Single-member LLC? Partner or limited partner? Shareholder in a close held corporation? Or, do you need to explore the formation and operation of a business entity to accomplish specific planning objectives? Skills I apply include the differences in formation, operation, and purposes of all the entities that can be established under Texas law. Each variety offers unique characteristics; and, those differences will be used to establish your enforceable plans. There are control issues – buyout issues – issues relating to locking out a co-owner’s judgment creditors – issues relating to liability for the conduct of a co-owner – and there are many other such things to be explored. Too, most people intending to establish a comprehensive plan frequently need to assure that capital and value are preserved, and that the benefits are transferred in orderly fashion to family members and others. This section summarizes entities that can be selected to accomplish your objectives.
Locking out outsiders:
When a co-owner’s interests are lost to creditors or claimants holding a judgment the rights to participation in management, rights to accountings, rights to access books and records and other rights can create serious disruptions. Under the law, there are specific alternatives to foreclosing many kinds of difficulties. Creating contractual, enforceable limitations in the nature of “assignee interests” is one method. Some of the other methods include these:
- creating specified buy-out rights VERY favorable to the option-holder(s)
- precluding admission of new interest-holders
- relegating new interest holders to the position of a mere “assignee” having no rights or powers, and
- other kinds of contractual features.
Which is a “best method” for your purposes? It depends on many factors such as the type of entity, intended objectives, any necessary funding alternatives, and other factors. There are many things that should be resolved to establish a coherent plan. Outsiders can acquire interests sufficient to disrupt businesses through a variety of doors. When an ownership interest is possessed by anyone who might become liable to another for any reason, it can open the door. If, for example, a judgment enters the picture the threat of losing that ownership interest raises issues. Texas law provides tools to minimize and sometimes eliminate the problems before they arise.
It doesn’t even require a written agreement for a general partnership to come into existence. General Partnerships (GP’s) are not a good alternative for purposes of operating business. Each partner is personally liability for all of the ugly liabilities incurred by any other partner in the course of business activity. There are many other detractive features about GP’s that firmly compel selection of other types of ownership to achieve these kinds of objectives:
- insulating you from liability for another’s conduct
- limiting the extent of another’s power to control the conduct of business
- assuring continuity of existence even when approved transfers of ownership interests occur
- facilitating transfer of ownership interests to members of your family, and other objectives not possible in a general partnership arrangement.
Since a general partnership arrangement exposes an owner to full personal liability for the acts of any other partner it can be prudent to become a “limited liability partnership.” To do so requires several steps. A specific election must be made, and various other requirements are imposed by statutes. For example, you might wish to review sections 152.801 and forward through this link. More about LLP’s is provided below.
Limited Partnerships and Limited Liability Partnerships:
The statutes governing formation and operation of Limited Partnerships (LP’s) and Limited Liability Partnerships (LLP’s) impose different requirements. But it’s not just the formation of an entity that is the focus of your planning concerns. Anybody can form an entity by filing the required documentation with the Texas Secretary of State. What matters is the binding and enforceable structure of the foundational agreements. They are contracts, and when inappropriate provisions are included – or worse, critically important provisions are omitted – one cannot unilaterally alter the private law established by the contract. One of the reasons why a strong contract is used is because other co-owners cannot decide to unilaterally alter the arrangement. The strength of the contract is one of the features that can block the reach of outside disruptive influences.
The statutes affecting these entities can seem deceptively simple on their face. The complexity lies in assuring that the contract – the private law – establishes exactly the controlling features required to implement a coherent plan. It becomes a matter of binding, enforceable private law that will govern the conduct of everybody. The Texas statutes governing formation and operations of LP’s can be reached through this link. And filing the paperwork converting an LP into an LLP is simple; but the statute governing that conversion refers to other parts of the law that must be located and followed followed step by step. For example, the following is the entire body of language prescribing the conversion into an LLP; but, you will notice it refers to other parts of the code. There are many other parts of the law that must be located and assembled into a coherent understanding of all the parts and pieces that comprise the law of LLP’s. Here are the fundamental provisions governing the conversion taken from the Texas Business Organizations Code, Chapter 153:
“Sec. 153.351. REQUIREMENTS. A limited partnership is a limited liability partnership and a limited partnership if the partnership:
(1) registers as a limited liability partnership:
(A) as permitted by its partnership agreement; or
(B) if its partnership agreement does not include a provision for becoming a limited liability partnership, with the consent of partners required to amend its partnership agreement;
(2) complies with Subchapter J, Chapter 152; and
(3) complies with Chapter 5.
Sec. 153.352. APPLICABILITY OF OTHER REQUIREMENTS. For purposes of applying Section 152.802 to a limited partnership: (1) an application to become a limited liability partnership or to withdraw a registration must be signed by at least one general partner; and (2) other references to a partner mean a general partner only.
Sec. 153.353. LAW APPLICABLE TO PARTNERS. If a limited partnership is a limited liability partnership, Section 152.801 applies to a general partner and to a limited partner who is liable under other provisions of this chapter for the debts or obligations of the limited partnership.”
The governing law is located in disconnected locations, but even that statutory framework does not address the most critical element involved – controlling the provisions of the contract that binds the parties. The most important features of becoming an LLP are described in other statutes that can be read at this link.
The Family Limited Partnership:
FLPs are bona fide business entities designed to hold a family’s assets together while protecting those assets from future creditors. It can ensure proper management of a large estate spread among many family members. It works like this — Partners in a limited partnership are either “general partners” or “limited partners”. General partners control the partnership. Limited partners have virtually no voice in the management of the partnership. Limited partners often have no guaranteed rights to distributions from the partnership, but may incur annual income tax liability as a result of the partnership’s business activities. [That can be a problem for the owners of such interests. Even if the income is not distributed, there will still be a Schedule K-1 issued, a report of the income made to the IRS, and the entire amount of the undistributed becomes includible in determining the amount of taxable income. The K-1 recipient will owe tax on income not distributed.]
Further, limited partners are often prohibited from selling their partnership interest to anyone other than a family member, thus keeping the business in the family. Restrictions such as these, while necessary to meet the family’s objectives, render a limited partnership interest somewhat unmarketable which severely depresses it’s fair market value. Depressed market value means a smaller estate for the IRS to tax. FLPs carry significant consequences to the family, and should be tailored to the family’s needs. Generally, family limited partnerships that carry the most significant restrictions are reserved to estates that exceed several million dollars.
While provisions barring the sale or other transfer (for example, through a judgment) make it impossible to liquidate interests, those same provisions protect every member of the partnership. It provides predictability of control and ownership and blocks all others from forcing their way into the mix. In exchange for surrendering the opportunity to convert an interest into cash or some other asset, owners acquire the value of knowing exactly who owns all the other interests. While the contract can block transfer by any means, one of the other realities to be brought into the arrangement is that things change – economic and business realities change through the passage of time. When it becomes prudent to terminate the partnership, liquidate its assets, end its affairs and distribute proceeds to each owner, the contract will provide ways to accomplish those things. Furthermore, where there are sound reasons sufficient to support the admission of a new partner, provisions can be included to tightly control those kinds of situations.
Family Limited Partnerships – just like ANY variety of limited partnership – can provide an excellent way to accomplish protection of assets, blocking outside influences, centralized management and control of assets, beneficial tax reductions, and other noteworthy objectives.
Limited Liability Company:
Limited Liability Companies are known as “LLC’s” for convenience. These organizations provide enormously flexible opportunities. Texas law governing formation and operation of an LLC is found in Chapter 101 of the Texas Business Organizations Code at this link. LLC’s can have one or more members, and under section 101.114 a member or manager is not liable for a debt, obligation, or liability of a limited liability company, including a debt, obligation, or liability under a judgment, decree, or order of a court. That’s a very strong protection. And while the statutes permit membership interests to be assigned, the effect of the assignment does not bring in a new member. Instead, the statute provides that the assignee is NOT entitled to participate in the management and affairs of the company; become a member of the company; or exercise any rights of a member of the company. Assignees merely receive whatever distributions their assignor would be entitled to receive. That too is an important protective device. All of the affairs of the LLC may be handled by members or by one or more managers appointed to run things – and managers do not have to be members or hold any interest in the LLC. But the way the LLC is going to be run must be designated in the documents filed with the Texas Secretary of State.
While the statutes are extensive and cover a very wide variety of matters, the most important part of the process is the company agreement – the contract that establishes all the important things. It is that specific document that will determine whether ANY assignee can ever be admitted as a member. Unwanted or disruptive intruders can be effectively blocked. Even judgment creditors of a member cannot force their way into the business – they can only obtain a “charging order” that entitles them to distributions the judgment debtor has. A charging order constitutes a lien on the judgment debtor’s membership interest. The charging order lien may not be foreclosed on under this code or any other law. A creditor of a member or of any other owner of a membership interest does not have the right to obtain possession of, or otherwise exercise legal or equitable remedies with respect to, the property of the limited liability company.
LLC’s offer powerful protections and vast management flexibility. They can be very appropriate as entities selected to protect assets and values, establish the required control, and facilitate management of business interests.
The “Close” Corporation:
As with all entities formed by filing documents with the Texas Secretary of State, the formation of a “Close Corporation” involves several bodies of law. Sections 21.701 and forward of the Texas Business Organizations Code can be perused through this link. The term “Closely held corporation” actually derives from federal law. Under federal securities laws the securities (stock) issued by such corporations is not traded on any public market. It is a violation of the law to offer those securities to the public in any manner. Further, the close corporation is typically owned by few shareholders. When the requirements of the Internal Revenue Code are met, the shareholders can specially “elect” status as a Subchapter S corporation. “Sub-S” corporations offer the distinct tax advantage of eliminating income taxation at the corporate-level. Under federal law, corporations are taxed on income, and the distributions made to shareholders can not be deducted in order to compute taxable income. As a result, the corporation is taxed and when distributions of profits are made to shareholders that same income is taxed again in the hands of the shareholders. Sub-S corporations are not taxable on ordinary income – all such income is taxed only in the hands of the shareholders. In essence, taxation is the same as if the corporation were a partnership.
Under Texas law shareholders are permitted to agree to a very flexible management structure for close corporations. They can even agree that all management functions shall not be vested in a board of directors – that all management shall instead be reposed in the shareholders themselves or in some management committee. One of the most important benefits is that shareholders may by contract place all manner of restrictions upon transfer of the shares. Outsiders can be effectively blocked from obtaining back-door rights and powers that could disrupt the ongoing business. There are close held corporations in Texas that are over a century old and that are very large businesses. All the stock continues to be owned only by descendants of the original owners. Divorces – deaths – judgment creditors – nothing has interrupted the continuity of the operations. Close corporations governed by shareholder-agreements provide strong tools to maintain control over all operations and to block outside influences. When unrelated persons own the corporation it is prudent to thoroughly explore the objectives that can be attained through binding shareholder agreements. Got questions? You can Ask Me.