Business Entity and Formation

The type of entity you choose for your New Jersey or New York business is one of the most important decisions when you are considering starting a small business. It is also important that an existing business review their entity choice to make sure they have chosen the most tax beneficial structure.

 We will gain a complete understanding of your business and ownership structure to help you select the most appropriate entity choice for your operations that will position you to achieve the most advantageous tax benefits. We can also advise you and help you create a methodical plan that will greatly increase your chances of growing and maintaining a successful business. We will help you avoid the common pitfalls that many new small business owners make when starting their new ventures.

There are several entity types to choose from, each of which generates different legal and tax consequences. It is important to select the proper legal structure of your company due to government filing requirements and long term business goals. Furthermore, there is no single form of entity that is appropriate for every type of business owner.

Choosing the appropriate form of entity in which to operate a business is a critical and complex decision. Making the wrong decision can cost a small business owner thousands of dollars annually just looking at it from a federal and state standpoint.

Making the right choice depends upon many factors, including the owners' needs and goals and the particular characteristics of the business in question.

Some of the most common forms of legal structure are:

• Sole-Proprietorship
• Partnership
• C-Corporations
• Limited Liability Corporations

Sole Proprietorship

A sole proprietorship is an unincorporated form of business with one owner who takes no action to form a separate legal entity. For tax purposes, the income and expenses of the business are reported on in the personal tax return of the owner (Schedule C, Form 1040). In addition to income taxes, the sole proprietorship is also subject to self-employment (Social Security & Medicare) taxes at a current rate of up to 15.3%.

Some advantages:

• The simplest form, especially if owner performs the majority of job functions
• It is free from legal formalities
• Most of the time, others can’t create obligations which bind you
• Since a sole proprietor is not considered an “employee” of a business, you will not have to pay unemployment taxes on your business income
• You can move monies out of your business account, and withdraw assets from the business with very few legal limitations and without paying taxes

Disadvantages:

• Sole proprietorships are limited in regard to tax breaks that are available to corporations for group-term life insurance, long-term disability insurance, long term care insurance and medical insurance
• No insulation from personal liability for business obligations
• No avoidance of trade name filing if business is done under another name

Partnership

A general partnership is an unincorporated entity (either U.S. or non-U.S.), with at least two owners, which is organized to carry on a trade or business. A general partnership is not registered in a specific state, since there is no formal registration required to form a general partnership. Instead, a general partnership comes into being as soon as two or more persons join together to own and operate a business. Partnership agreement not required, but desirable. Ownership of a general partnership is in the form of partnership units, shares, or percentages. A general partnership must have at least two owners, but there is no upper limit on the number of owners. In addition, there are no restrictions on the kinds of owners that can be partners.

Liability protection – A general partnership ordinarily owns its assets, although not always. Sometimes property is held in the name of individual partners, and is used in the partnership. A general partnership is nominally responsible for its own debts; that is, money may be borrowed in the name of the partnership. However, general partners are also personally responsible for all partnership recourse debt.

Transfer of income to partners – A general partnership can hire employees who are not partners. Partners, however, are not employees of the partnership. Such partners may provide services to the partnership, and be paid for those services; however, the partners are not classified as employees.

Employees of a general partnership are eligible to receive a variety of tax-free fringe benefits, such as health care. However, partners cannot receive these benefits tax-free. Both partners and employees, however, can participate in company-sponsored retirement plans.

Taxation of a general partnership – A general partnership does not pay tax.

Taxation of partners – Partnership is a tax-reporting entity. Must prepare and file informational returns, even though income and losses are flowed through to the individual partners. Partners are taxable regardless of whether that income is distributed to partners in the form of cash or property. Like a sole proprietor, a partner is also subject to self-employment tax at a rate of up to 15.3%.

Advantages:

• Partners can deduct losses recognized at the partnership-level on their personal tax returns. This is one of the great advantages of a general partnership. However, the ability to deduct losses is subject to a number of limitations. In general, partners can deduct losses equal only to their investments in the company (in the form of capital contributions, and share of partnership-level liability). In addition, partners are limited in their ability to deduct losses if they do not actively participate in the business.
• Expanded sharing of management responsibility, i.e., “two heads are better than one”
• Minimal legal formalities: A Trade Name certificate must be filed if you do business under any name other than names of all partners
• Limited duration: No formal action is required in order to terminate the partnership

Disadvantages:

• Potential for deadlock if partners don’t agree on management of business
• Each partner is personally liable for partnership obligations incurred by other partners
• Partnership interests are not freely transferable by a partner
• Unless the partnership agreement otherwise provides, the death or bankruptcy of a partner, or the unilateral decision of a partner to withdraw from the partnership, will result in the dissolution of the partnership

Corporation

A corporation is a separate corporate entity and separate legal person (either U.S. or non-U.S.). A U.S. corporation is organized in a single state, although the corporation may do business in many states. A corporation comes into being when its organizers file articles of incorporation with a state (or country, in the case of a foreign corporation).

Advantages:

• A corporation owns its assets and is liable for its debts. Shareholders are not liable for corporate debt. The fact that the shareholders are not liable for corporation debt is one of the primary advantages of the corporation as a form of business. This is especially important in today’s sue happy environment.
• Centralized management in the corporation’s board of directors
• Continuous existence. The corporation does not cease to exist upon the death or bankruptcy of a shareholder, or the decision of a shareholder to withdraw from the business
• Acceptability of business format makes it easier to raise equity financing (e.g. sale of shares to investors), and debt financing (e.g. bank loans or other loans)
• Use of corporate stock to “incentivize” key employees
• Unless restricted by corporate documents, shares of stock are freely transferable
• As noted above, corporations receive favorable tax treatment for certain fringe benefit plans, including medical insurance, disability insurance, and group-term life insurance
• Estate planning – The C corporation is a useful device for minimizing estate and gift tax. In general, stock in a C corporation is often valued (for estate and gift tax purposes) at a discount to the value of assets owned by the corporation.

Disadvantages:

• Expense of incorporation and recurring expense of annual franchise or corporate income taxes
• Need to observe corporate formalities, including annual meetings of shareholders, regular meetings of directors, maintenance of corporate minutes and other corporate records, and filing of annual reports with New Jersey Secretary of State
• Consideration of federal and state securities law questions in issuance of capital stock
• If business is conducted in other states, corporation may need to apply for a certificate of authority in such other states
• Duplication in licensing, i.e., both individual and corporation may be required to file
• Transfer of income to shareholders – Shareholders who provide services to a C corporation are treated either as employees or independent contractors, depending on the specific circumstances, and are taxable on compensation received. When shareholders are employees of a C corporation they are eligible to receive tax-free fringe benefits, such as health care benefits. They can also participate in company-sponsored retirement plans.

Tax Implications:

• For tax purposes, corporations are either regular corporations, referred to as “C” corporations, or “S” corporations. In order to qualify for “S” corporation treatment, you must meet strict requirements and file an “S” election on Form 2553 on a timely basis
• “C” corporations are subject to two levels of taxes: once at the corporate level and again when the corporation makes distributions to its shareholders
• “S” corporations escape double taxation since they operate as pass-through entities. The corporation generally pays no tax on its income; the shareholders are taxed at their individual rates on the corporation’s income. The “S” corporation combines the best features of the corporation (limited liability) and the partnership (one level of taxation)

Limited Liability Company (LLC)

A limited liability company (“LLC”) is a hybrid entity that is treated like a corporation for limited liability purposes, but, for tax purposes can choose to be taxed either as a corporation, partnership, or disregarded entity (single-member LLC). An LLC is created under state law by registering under a state LLC statute. Like corporate shareholders, LLC members are not personally liable for the obligations of the LLC; instead, their liability is limited to their financial investment in the enterprise. Unlike a limited partnership, where general partners remain liable for partnership debt, all members of an LLC have limited liability.

For an LLC that chooses to be taxed as a partnership, the tax rules are the same as those of general partnerships, except for minor differences. Similarly, an LLC that elects to be taxed as a corporation will be taxed in the same way as a corporation.
Comparison of the LLC with a C corporation.

C corporation shareholders are double taxed — once at the corporate level and a second time at the individual level as shareholders

Shareholders in a corporation and members in an LLC both enjoy insulation from personal liability for debts of the entity
In addition to limited liability of shareholders, corporations have 3 other attributes:

• “Continuity of life”, i.e., corporations live forever and don’t terminate if a shareholder sells out or dies, etc.
• “Free transferability of shares”, i.e., shareholders are free to transfer their shares to others, unless there is an agreement to the contrary
• “Centralized management”, i.e., as a technical matter, the business of the corporation is managed, not by the shareholders, but by a board of directors.

LLCs will automatically be given pass-through tax treatment, unless they elect to be taxed as corporations.

Corporations generally are required to be managed by a board of directors which, in turn, appoints officers to run the day-to-day affairs of the business. These rules do not apply to LLCs. LLCs are not required to have directors or officers. The management of the business can be done by the LLC members, or the members may appoint managers

A corporation must observe certain formalities in terms of shareholder and director meetings, maintenance of corporate minutes, and filing of annual reports. Failure to observe these formalities can lead to “piercing of the corporate veil”. The LLC has no such corporate formalities
In the C Corporation, there is often a genuine concern about the ability of the IRS to claim that shareholder-officers of the corporation have received “unreasonable compensation”. The consequence of such a determination by the IRS is that the “unreasonable” portion would not be deductible by the corporation, and would, therefore be subject to double taxation. Since the LLC is not subject to two levels of tax, unreasonable compensation concerns are eliminated

Comparison of LLC with S corporation:

• Both LLCs and S corporations offer pass-through taxation at the federal level
• Both LLC and S corporations afford members/ shareholders insulation against liability for the debts and obligations of the entity
• However, S corporations are subject to a number of tax rules that do not apply to LLCs:
• S corporations may issue only one class of common stock, and no preferred stock. LLCs can have flexible capital structuresS corporations cannot have more than 75 shareholders. LLCs may have an unlimited number of members
• S corporations must properly complete and timely file various tax forms. LLCs have no such filing requirements

How do you know if an LLC is right for your business?

• The LLC provides the same limitation on personal liability and pass-through tax treatment as an S corporation, without the need for various S corporation tax filings
• Avoid the need for a board of directors. All members of an LLC can participate directly in the management of the company, without the need for a board of directors
• Avoid the need for a shareholders agreement. In order to prevent free transferability of shares of stock of a corporation, you need a shareholders agreement. By law, however, the interest of a member in an LLC cannot be transferred without the consent of all the other members. This alleviates the need for a shareholders agreement. However, every LLC requires an “Operating Agreement”. The Operating Agreement takes the place of corporate by-laws and organizational resolutions, and, in most cases, will cover many of the same subjects as a shareholder agreement
• The combination of limited liability, pass-through taxation, and relaxed rules for non-U.S. investors and flexibility in capital structures will make the LLC the vehicle of choice for situations involving passive investors, non U.S. investors and joint ventures.

Annual Minimum Fees

In choosing the proper form of entity in which to do business, it is important not to discount annual fees required by states. Fees in New Jersey and New York change frequently so please consult our office on current fees for those respective states or any other you may be considering.

Disclaimer: All material on this page is for education purposes only. Laws change frequently. You should consult with your CPA and attorney before making any legal decisions regarding your small business. We welcome the opportunity to sit down with you to discuss your goals. If you do not have legal representation we can make a recommendation that will suit your needs. Give us a call at 201-592-0006 today!

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