Corporations and LLCs

flickr photo shared by Matt Niemi under a Creative Commons ( BY-NC-ND ) license

Last week we looked at sole proprietorships and partnerships, two forms of business ownership that share the advantages of easy formation and management flexibility, but which also share the disadvantages of a low ability to raise capital and unlimited personal liability. This week we turn to corporations and LLCs, which provide limited liability for business owners and make it easier to raise capital.

Corporations are a form of business ownership that allow for limited liability of the owners, known as shareholders. Corporations have some very significant advantages over sole proprietorships and partnerships. They have a perpetual duration, so that they can go on for generations, and they’re easy to transfer, so it’s simple to sell the business to a new owner. They also make it easy to raise a great deal of capital because shareholders aren’t liable for the debts of the business. Need more capital? Sell more shares. The biggest advantage of a corporation is limited liability. The owners of a corporation have some risk if the business fails—they can lose what they’ve invested—but their risk is limited. They can’t lose any more than they’ve invested and none of their personal assets are at risk. Corporations have the disadvantage of increased complexity, expense of formation, and regulation. To form a corporation, a business owner will usually hire an attorney to draft articles of incorporation to be filed with the secretary of state. Corporations also have a more complicated structure—shareholders are the owners of the corporation, but they don’t have direct control of the business. Instead, they elect a board of directors who hire corporate officers, and the officers, who are employees of the corporation, manage the company. To make sure that shareholders retain some control of their investment, a corporation is required to have a shareholders’ meeting once each year. The shareholders get a financial report and elect directors. If they don’t like the way the company is being run, they can elect a new board who will then hire new officers. That’s fine for a big corporation like Walmart, but what about a small, one-owner corporation? Seems kind of silly to send yourself notice of a meeting with yourself, then elect yourself to the board of directors so you can hire yourself as CEO, right? What if you just skip it? It’s not like you’re going to sue yourself in a shareholder’s derivative lawsuit, right? If the corporation gets sued, however, a plaintiff’s attorney may ask for minutes of annual meetings, and may ask the judge to rule that the business is a sham corporation and to pierce the corporate veil, holding the owner personally liable and removing the limited liability that was one of the main reasons for creating a corporation in the first place.

Almost every textbook warns of the dangers of double taxation for a corporation. While it is technically possible, in practice, it doesn’t happen much and is usually the result of poor tax planning. Most small corporations are subchapter S corporations, which don’t pay any tax at the corporate level, and large corporations use the tax code to eliminate most or all liability. In 2010, GE had $14Billion in profits (not revenue!) and still paid 0$ in US corporate income taxes. Many large corporations pay an effective tax rate of 0%, and some corporations even manage a negative tax rate of as much as -58%.

Finally, we have the limited liability company, or LLC. An LLC combines the best features of a partnership and the best features of a corporation. Like a partnership, LLCs provide flexible management and have no requirement for an annual meeting. An LLC can be managed by its owners (called “members”)—like a partnership, or managed by professional managers—like a corporation. Most importantly (as you’ve probably guessed from the name), LLCs provide their owners with limited personal liability. LLCs also have great flexibility when it comes to taxation. They can either be taxed as partnerships, avoiding any risk of double taxation. However, if corporate taxation is more advantageous, LLCs can be taxed as corporations in stead. Not only that, but LLCs can change from year to year, depending on which type of taxation is better.