For individuals starting a business, the form their business takes is important and hinges on their desire to protect their investment (limited liability), enjoy flexibility in management and administration, and the ability to maximize profit by paying taxes on earnings directly, rather than at the entity level and again individually on distribution. Before 1994, New Jersey businesses wanting limited liability without double taxation used “S’ corporations. After 1994, business owners could chose primarily between “S” corporations and the limited liability company (“LLC”).
Before 1994, “S” corporations were preferred because of limited liability and flow-through taxation. For an “S” corporation to pay taxes through the shareholders directly, certain requirements are necessary. “S” corporations may only issue one class of common stock, other business entities and non-U.S. persons cannot be shareholders, and “S” corporations can have no more than 75 shareholders. Additionally, an “S” corporation is required to abide by sometimes rigid corporate practices to preserve limited liability, such as conducting meetings of shareholders and directors, maintaining minutes and making annual corporate filings. Also, shareholders of an “S” corporation can sell or transfer shares absent a shareholder agreement otherwise (subject to securities laws restrictions).
LLC’s combine the best features of a corporation (limited liability) with the best features of a partnership (flow-through taxation), while offering greater flexibility in management and ownership structure. An LLC is automatically taxed at the owner level without the need for corporate tax filings, unless the LLC elects to be taxed as a corporation. LLC’s may also have any number of members and those members may be other businesses or non-U.S. persons. The structure of the management of an LLC is more flexible, does not require duplication of paperwork and individuals playing multiple roles (shareholder and director), and is done with substantially less confusion.
Several LLC limitations have resulted in the continued viability of the “S” corporation. In an “S” corporation, a shareholder-employee pays self-employment tax on money received as compensation for services, but not on profits that pass through as a shareholder. Thus an owner can still be paid a salary, and only pay additional self-employment tax on the “reasonable compensation” portion of total distributions. The entire distribution drawn by an LLC’s member-employee is treated as a “guaranteed payment” meaning all payouts are subject to self-employment tax. The second factor is that if it is expected that the business will require institutional investment, most institutional investors will require that the business be a “C” corporation (versus an LLC or “S” corporation). An “S” corporation need only “unelect” their flow-through status to be treated as a “C” corporation to raise institutional investment, while an LLC would have to undergo a cumbersome conversion process.
Sorting through the characteristics of these business forms can be daunting for business owners, and making changes once a business is established can be difficult and costly. As such, individuals forming businesses should consult with legal counsel and accountants to review the characteristics of each entity important to their businesses.