Corporations are legal entities – they can “own” assets and “act”.
What does this mean?
It means that a Corporation as a legal entity can own things – like computers or other office equipment. It can owe other corporations or individuals and it can also sue or be sued in a court of law.
And this is one of the big reasons why individuals when running a business elect to create corporations.
A corporation as a legal entity provides legal liability to an individual.
In this article we are going to examine legal liability of corporations and ask the question if legal liability is fair.
We’ll also take a look at how corporations and the individuals who own them are taxed and ask the same question of fairness.
What is Limited Liability?
As I said above, one of the big reasons that individuals create corporations is for limited liability.
But what is limited liability?
When a person forms a corporation, he or she transfers ownership of assets to the corporation. The corporation now owns these assets and the person has ownership in the shares of the corporation.
Now if for some reason the corporation is sued then the claimants are suing the limited liability corporation not the individuals.
Let’s look at an example:
Let’s say I have ownership in a computer security company – Glennon’s Security Service.
The company is a limited liability corporation and owns the following
- $80,000 in computer hardware
- $50,000 in software
- $20,000 in various office equipment.
- $500,000 in insurance
Now let’s say I have a client who claims his business was ruined as a direct result of a job that we did and decides to sue me for $2 million in damages from a breach and the court decides in his favor.
So the client would be able to get $650,000 from the court victory because that is the total of the asset owned by the company.
I would of course lose my ownership in the company and it would go bankrupt but I would not be liable for the remainder of the court award because the corporation gives me limited liability protecting me by making the corporation a legal entity.
Is this fair?
I mean after all the client lost his livelihood and he didn’t get everything he was awarded which would have gone a long way to helping him recover.
Well, it’s kind of a tradeoff.
If I didn’t have limited liability I may not have started my business. I would have not wanted to be exposed to all the risk of being sued. And I wouldn’t want to lose all my assets.
I could perhaps get more insurance to cover my potential risks but that would cost even more. Maybe the risk and the extra costs associated with creating and running the business would have put me off.
There is another tradeoff to limited liability as well that balances out the protection of a corporation being a legal entity – double taxation.
What is Double Taxation?
Double taxation only happens with C-corps.
There are other types of limited liability corporations – LLCs and S-corps for example but I’m only focusing on C-corps here.
If a corporation makes $1000 in a given year for example, the government will tax that corporation like a person – say at 30%.
The corporation now has a net profit of $700 which is paid out as dividends to the shareholders.
If I am 100% shareholder I would receive the $700 and then have to pay taxes on the income. Let’s say that is also 30% – which leaves me $490 net profit. Now remember this is a simplistic example as there could be variations on the taxation of dividends.
Is it fair to be double taxed?
Well it could be argued that in exchange for paying the taxes twice you are getting the benefit of limited liability.
If you don’t want to be double taxed you don’t need to form the corporation.
But then of course, by not forming the limited liability corporation your assets are exposed.
Limited Liability and Double Taxation
We have seen that limited liability is a protection for a corporation shareholder to shield his or her assets from legal action.
As a “cost” of getting limited liability corporations themselves pay taxes and then shareholders who get a dividend are also taxed for the amount of the dividend.
So it may appear that limited liability and ”double taxation” are unfair. But they really balance out as compromise for encouraging businesses.