In the business world, corporations are your tanks; if put together correctly, they soak up all your “damages” from litigious bad-guys. In fact, they’re better than tanks, because they always do exactly what you (its Board of Directors) wants it to do, rather than going off on its own epic (and ultimately suicidal) detour. Your corporate “entity,” yes we lawyers call it an entity, gives you and all of your partners (in this case “shareholders”) what is called “limited liability.”
Put simply, limited liability means that if your company is sued, the person suing your company can only get the assets of your corporation; they can’t get a judgment against your own personal property. This is a very valuable distinction. To stick with our tank metaphor, even if a plaintiff wins a lawsuit against your business, they can only get the items that your corporation owns (so they could pick up your tank’s armor, weapons, and potions, but couldn’t go after your staff of awesomeness).
What’s that? I’m using the tank metaphor too much? Okay, let’s try another one…
Your company makes a highly addictive game called Ever-Crack, which is sold to millions of people between the ages of 5 and 90. Little Suzy Boo-Hoo, who is no more than… five, plays your game so much that she forgets to eat and sues your company for her general malnourishment. Let’s say that the jury agrees with her side and awards Suzy $500,000 against your corporation for creating the game and selling it to a 5 year-old, knowing that it would cause her a tragic lack of nom-noms.
If your company is just a partnership and therefore does not have “limited liability,” Little Suzy would be able to satisfy the judgment by taking all of your private property (computer(s), house, car, TV, your original Nintendo), and selling it all in public auctions until her $500,000 judgment is paid.
(As an aside, simple partnerships are usually okay for the early stages of your company because limited liability is rarely an issue until you’re actually selling something. In the beginning, it’s usually much more cost effective / appropriate to make a simple partnership than it is to make a corporation.)
The drawbacks of corporations are many: You have to respect what’s called “the corporate form.” This is legalese for “you have to deal with all the red tape no matter how odd or unnecessary it seems to be.” The red tape includes having scheduled corporate meetings, tracking your corporate minutes (someone actually has to write down all the topics discussed at your corporate meetings), keeping separate bank accounts, keeping everything ‘owned’ by the corporation completely separate from your own assets (so you can’t drive your company car to your date or play Starcraft on your corporate computer), etc. The costs of all this red tape adds up, but the real costs come from:
With corporations, you lose money to double taxation. When your corporation profits, it’s taxed on those profits immediately, even though you don’t see any of that money yet. Then, after your corporation is taxed for the profits, you are taxed on whatever money you get from the corporation!
So if Ever-Crack corporation makes $100,000 in its first year, it would be taxed, lets say, 34%, leaving Ever-Crack Inc. with $66,000. Then it makes a “distribution to its shareholders,” which is just a neat way of paying its owners, all of these profits. Each shareholder would then have to pay their own taxes on that $66,000 based on their individual tax rate. So if your personal tax rate is 34%, and you received the full $66,000 from your corporation, you’d have to pay an additional $22,440 to Uncle Sam, leaving you with only $43,560 of the initial $100,000 that Ever-Crack Inc. made in profits that year!
Thankfully, there are new legal entities that, like corporations, have limited liability, but don’t suffer from the double-taxation problem. Like partnerships, they have “pass through tax” systems that prevents this from happening (see more on this in the upcoming Blog 3: LLCs and LLPs).