Should I incorporate?

Limited Liability Companies Provide Tax and Other Advantages©2000
By J. Kenneth Harris, Esq.   Harris Law Offices

You're starting a new business and want to know should I incorporate/form a corporation to operate the business. For the past six years businesses in New Jersey, like those in 49 other states and the District of Columbia, have been able to both minimize their tax burden, and limit the personal liability of their owners, by operating as a limited liability company (“LLC”) rather than a corporation, partnership or other business form.

A LLC is a relatively new type of company, which gives the owners of the LLC, referred to as members, the liability protection found in corporations. Further, if certain requirements are satisfied, an LLC is taxed like a partnership for federal and state, in most cases, income tax purposes. Being taxed like a partnership means that there is only a single level of tax on the profits of the LLC, paid by its owners unlike a regular corporation where profits are taxed at the corporate level and again when they are distributed to the shareholders as dividends. If the LLC satisfies the IRS requirements for being treated as a partnership, the profits and losses of the LLC will pass through to the members and be reported on their separate tax returns without any double taxation. This is particularly important to new and growing businesses that incur loses in their initial years and subsequently desire to retain profits to help them expand. Additionally, they are an excellent vehicle for joint ventures where the parties want to split the revenues and expenses of the activity and limit their liability to the assets contributed to the joint venture.

In order to be taxed as a partnership, rather than a corporation, the LLC must be organized and operated so that it does not have more of the characteristics that are associated with being a corporation rather than a partnership. The IRS has established four factors, which they consider to be indicative of a corporation. If an LLC is to be taxed as a partnership, it may have no more than two of the four following corporate characteristics: (1) limited liability, (2) continuity of life, (3) centralized management and (4) free transferability of interests. Since one of the principal objectives in selecting the LLC as a form for conducting business is limited liability, an LLC cannot have more than one of the other three factors if it is to be taxed as a partnership. It is important to have professional advice when organizing an LLC to ensure that the IRS requirements for being taxed as a partnership are satisfied. The IRS, having been swamped with ruling requests as to whether a particular entity qualified to be taxed as a partnership, as compared to a corporation, adopted “check the box” regulations in January 1997 to provide that LLCs with 2 or more members would be taxed as partnerships. Consequently, after 1/1/97, an LLC with 2 or more members will be treated/taxed as a partnership absent an affirmative election to the contrary. (In some states an LLC may be treated as a corporation for state income tax purposes.)

The members/owners of an LLC will not, as a matter of course, be personally liable for the LLC’s debts or obligations. Consequently, much like shareholders in a regular corporation, only their investment in the LLC is at risk for the company’s liabilities and not all of their other assets. While an S-corporation offers limited liability and pass-through taxation, an LLC is superior because, unlike the S-Corporation, there can be an unlimited number of LLC members, a corporation or non-U.S. person may be a member, and the single class of stock rule is not applicable. This last feature permits great flexibility when allocating the LLC’s profits and losses among the members. For example, different allocations of income and loss may be made between members in recognition that one is primarily the investor and the other runs the business. All members of the LLC may participate in its management without sacrificing their limited liability, unlike a limited partnership where limited partners cannot participate in management without losing their protected status. However, it is also possible for the members to designate specified individuals/entities as “managers” with the power to control the operations of the LLC. If “managers” are appointed, and they needed not be members of the LLC, they control the operations and management of the LLC in accordance with the powers given them in the LLC operating agreement.

The methods of operation and management of an LLC are set forth in its Operating Agreement. The Operating Agreement is a document which states the rights and responsibilities of the members and the manner in which the LLC will be operated. Some of the common issues addressed by the Operating Agreement are:

1. the name, office address and registered office and agent for service of process
2. purposes of the LLC
3. names and addresses of members
4. management structure, powers and duties
5. meetings and voting rights
6. required capital contributions and allocation of profits and losses
7. books and records, tax year
8. right to transfer interests in the LLC and buy/sell provisions
9. admission of additional members
10. dissolution/termination

LLCs are becoming more widespread in their use as they are recognized as a valid form for doing business in all fifty states. They can be formed, much like a corporation, by filing a Certificate of Formation with the Division of Revenue, Department of the Treasury and preparing an “Operating Agreement” which sets forth the terms for the management of the LLC, and the rights and duties of the members. The Operating Agreement is somewhat similar to a detailed partnership agreement associated with limited partnerships. Owners starting new businesses who want limited liability and simplicity of partnership taxation should consider using a LLC. Existing businesses thinking of forming a joint venture with another company or creating a new division may also want to consider using a LLC due to its flexibility, pass-through taxation and limited liability features.