New Jersey Formation: Choosing the Optimal Structure: LLC or S Corporation?

It is important to consider certain essential factors when choosing which type of business entity for your new business.  In order to reach your goals and find the best fit for your company, you should consider protection from liability, taxation mechanisms, ease of formation, and your future requirements for raising capital. The two primary options for small businesses are the limited liability company (“LLC”) and the S Corporation (“S-Corp.”). The LLC is the structure most commonly used by small business owners, but it is important to review the S-Corp. before making your decision and forming your entity.   Once you understand the similarities and differences between the two structures, you can review your business goals and needs to make an informed decision as to which type of entity you should form.

The Limited Liability Company

Under the New Jersey business law, the LLC provides liability protection similar to that of a corporation while retaining the taxation structure of a partnership. For tax purposes an LLC is a “disregarded entity”, the LLC issues a K-1 form to each member at the end of the tax year showing the distributions made to each member.  This K-1 is used to prepare each member’s individual income tax returns.  An LLC is quite flexible as to the forms of management which are permitted.  It can be member-managed in that the members (owners) manage the business of the LLC; or manager-managed, in that an outside manager is hired to manage the business affairs of the LLC; or some combination of the two models. Additional flexibility is found in the LLC because profits and losses can be allocated in any way desired by the members, it does not have to be based on the amount of capital contributions contributed by each member. The operating agreement is the controlling document and it can be drafted to reflect the agreement of the members.  The operating agreement can also reflect different voting rights among the various members and it can relax the strict recordkeeping rules of a corporation.

The S Corporation

The S-Corp. begins as a standard corporation and after it is formed an S election is filed with the Internal Revenue Service, which designates that the corporation will be taxed pursuant to Subchapter S of the Internal Revenue Code. The S-Corp. status permits the corporation to avoid the double taxation imposed on a standard “C” corporation just like a limited liability company.  It is instead taxed taxed as a partnership where the profit or loss flows through to the shareholders’ (owners’) personal income tax returns. The S-Corp. also protects its owners by limiting the personal liability of the owners.

However, the S-Corp. structure requires adherence some rather strict rules:  For example, a shareholder must be a U.S. citizen or resident:  There can be no more than 100 shareholders: Profits and losses must be allocated based on proportion of ownership:  Shareholders must be individual – business entities are not permitted to be shareholders: An S-Corp. can only have one class of stock.

Comparison Chart

                                                S-Corp.                                         LLC

Owners                                    Shareholders                                 Members

Number of Owners                 Unlimited                                      100 Maximum

Classes of Equity                    Multiple Classes                            One Class

Types of Owners                     US Citizens & Residents              Anyone or any Entity

Equity                                     Stock                                             Membership Interests

P/L Distribution                      According to Ownership              Anyway Members Decide

Management                           Officers & Directors                     Officers, Directors, Managers,

Members or as decided by Members

Controlling Documents           By-Laws & Certificate of             Operating Agreement and Incorporation  Articles of Formation

Employment tax                      Payroll deductions                        Liable for self-employment tax
At first glance the LLC and S-Corp. structures seem quite similar.  But as you can see, under New Jersey’s Business Laws a number of significant differences between the two entities.  The LLC is clearly more flexible and can be less formal, which is dictated by the operating agreement.  While, an S-Corp. must maintain the formalities of a corporation required by New Jersey law, http://law.justia.com/codes/new-jersey/2013/title-14a in such as board meetings, shareholder meetings, election of directors, recordkeeping procedures, etc.  An S-Corp. is a corporation for all purposes other than taxation.  It is managed by its officers and directors, and the management structure cannot be altered.

The formalities of the S-Corp. come with a possible advantage: employment taxes.  LLC members are self-employed and they must pay self-employment tax, including Social Security and Medicare payments. On the other hand, if a corporation pays a salary to a shareholder, the shareholder is an employee of the corporation subject to standard employment taxes. The corporation must file employment forms with the state and federal government, and by filing periodic payroll taxes, the “S” corporation may save some money on employment taxes.  Review with an accountant is necessary to determine the savings which may result for the S-Corp. structure.

More and more small businesses are utilizing the LLC structure because it offers the limited liability of a corporation, the  taxation of a partnership, and the flexibility of the operating agreement to determine how the business is run.  The benefit of an S-Corp. is the potential  employment tax savings, but each business needs to assess if the savings are worth the formalities required.

The attorneys at McLaughlin & Nardi, LLC can assist you in navigating potential pitfalls associated with each entity because every business is different and requires serious consideration before selection and formation of the business entity.  Please contact us by telephone at 973-890-0004 or e-mail.