Many businesses are formed as a limited liability company or and S-Corporation or a Partnership but what’s the difference? Which is better? I get that question a lot and unfortunately can not tell you which to choose however, below is a short article on the history of corporations and you may be able to answer that question for yourself. If you are still unsure on whether to form an LLC or Corporation you may find it useful to consult a business law attorney on the benefits of each and then once you make a decision we will be happy to form the business entity for you.
A BRIEF HISTORY OF
CORPORATIONS
IN
THE UNITED STATES
Before corporations existed in this country if you were a business owner all of your assets were at risk in the event of a lawsuit. By “all of your assets” I mean both the assets used in the operation of the business and your personal assets. So, when the lawsuit came, and sooner or later they generally do, all of your assets were subject to attachment if a judgment was entered against you.
Small businesses are the backbone of this country’s economy; it always has been that way and always will be. So, the government wanted to create an incentive for people to start a business. In the early 1900’s legislation was passed which offered business owners some protection by allowing them to separate their personal assets from their business assets. Personal assets continued to be held in the name of the individual who owns them. However, business assets could be held in a legal entity called a corporation. Corporations are created by drafting a document known as Articles of Incorporation. This document is filed with the Corporation Commission or the Secretary of State as a public record. The Articles of Incorporation are also published in a newspaper of general circulation; viola, a corporation is born.
It may be useful to think of a corporation as a fictional person, because that is how it is treated in many respects, as if it were a person. What generally happens when a real person is born? They get a social security number. Well, so does a corporation except it is called a tax ID number.
What happens when the lawsuit comes? Well, if it was the corporation that caused the event, which results in someone being damaged then it is the corporation that is subject to the lawsuit and judgment. And it is the corporation’s assets that are subject to attachment. Your personal assets are protected by the “corporate veil”. The corporate veil is the wall between your personal and your business assets.
Is the “corporate veil” impenetrable? No. In order for the “corporate veil” to be effective there are many administrative hoops that must be jumped through, like annual meetings, minutes, resolutions, annual reports and filing fees along with separate and more complicated tax filings. If these administrative tasks are left undone then when the lawsuit comes the attorneys will attempt to “pierce the corporate veil” and get to your personal assets.
One big disadvantage to having a corporation is the issue of “double taxation”. If we think of a corporation as a fictional person, with its own tax ID number then that fictional person must pay income taxes on its net income. Ok, so what’s the problem? Well remember, you have to run a corporation like a business otherwise you will not be afforded the protection of the “corporate veil”. So if you own the corporation and have its net income at your disposal how do you get that money to pay your personal bills every month? You can’t pay your personal bills out of your business bank account. Only business expenses are paid out of a business bank account. The answer is that the corporation has to pay you as either an employee or a stockholder. You will either write yourself a paycheck as you would to any employee and pay all the necessary withholdings like social security, Medicare etc, or you can pay yourself a dividend, which is also subject to income taxes. Either way all the money that comes into the corporation will be taxed twice. Once as income to the corporation and then again when you pay yourself either a paycheck or a dividend. This type of corporation is commonly known as a “C corporation”. And chances are if you are starting a small business this double taxation issue will dissuade you from selecting this type of corporation or even starting a corporation at all, as it did many others who came before you. So, Congress came up with a new type of corporation with the intent to eliminate the double taxation issue and it is known as the “S corporation”.
An S corporation is considered a disregarded entity for tax purposes. So the net income of the corporation is not taxed instead it “passes through” to the owner’s tax return and is taxed only once. An S corporation still provides a “corporate veil” so these two benefits made it a very popular choice for small business owners. But, the “corporate veil” still required quite a bit of administrative maintenance to be effective. So, in the 1970’s another hybrid corporation was born, the Limited Liability Company (LLC).
LLCs offer disregarded entity tax status and almost no administrative requirements to maintain an effective “corporate veil”. In order to form one a document known as Articles of Organization is drafted, filed with the Corporation Commission, and a Notice of Filing is published in a newspaper. The Corporation Commission will send out a “check the box” annual report that must be completed and returned with an annual filing fee. LLCs offer a simple and easy way to separate your business assets from your personal assets. Check with your local paralegal/certified legal document preparer to find out more about how an LLC is formed, operated and maintained in good standing.
