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Current time:0:00Total duration:10:18

Is limited liability or double taxation fair?

Video transcript

Voiceover: After watching the last video on corporations and limited liability, you might be asking yourself was that fair if Bill had owned the cab himself and got sued, the soccer player who's career was ruined would have gotten his actual million dollars. Because Bill set up this corporation and put the assets of the cab company in this corporation, he was able to limit his liability. The soccer player was only able to get a $180,000, the corporation declared bankruptcy but Bill's liability was limited to what he had contributed to the corporation. He might say, "My God, this guy over here" "his life was somewhat ruined" "and he's not able to kind of get compensated" "for I guess how bad his life was ruined." Bill is so rich, he could probably still make money. He should give him the money, so he should say this is kind of an unfair way that this corporations are a way for well off people or wealthy people to protect their assets. To some degree that's true. I want to think about in this video is the trade-offs and really this is just a balance that society has to pick. That this really was on ... At least the way I had set it up in the last video was kind of unfair to the soccer player. I mean he was only getting a $180,000 for something that might have ruined his career. If you had talked to Bill, Bill might have said well, "That's right," "corporations are kind of limiting liability" "for someone like me." He'd say, "Look I wouldn't have started ..." or maybe he wouldn't have started the cab company if he didn't have that limited liability. He said, "Look if I had all of these assets" "maybe he had a million dollars." Or actually he does have a million dollars, maybe he had a hundred million dollars. He said, "Look, if I had a hundred million dollars" "and I didn't have the option of starting a corporation," "I would have not have started the cab company" "because just for a little bit of small profit" "that I could have gotten from $80,000 cab" "I wouldn't have wanted" "to jeopardize the rest of my empire." "If I didn't have limited liability," "I wouldn't have started the business to begin with" "and that would not have been good for society." Another argument Bill might make and I'm not going to take sides here, I'm just saying these are the bounds, these are the things that you have to weigh when you set up a legal code in the society, is that Bill said, "Look, whoever starts a cab business," this cab business that roughly you could start with 80, 90, or $100,000. They all have the same upside. They're taking a certain amount of risk, they're providing a service to the city. They'll probably make a similar amount of money. He would argue that it would be unfair that we have different downsides. Maybe Sal right over here, maybe my only assets are the cab plus licenses and I have 80K over there, and the insurance which is 1K. What Bill would say is, "Look, me and Sal" "could both open the exact same cab business" "and if there were no corporations," "if I had to own ..." When I say I, I'm talking about Bill. If Bill had to own the assets of the cab company or I should say the cab company, I should say Bill had to directly own the assets, the cab and licences. Even though Bill's and Sal's upside from the business, the profit they could make would be the same. Bill's downside would be more because he has ... If he didn't have the corporation, he would have all of these other assets at risk. Maybe that would make Bill get a bigger policy so that a $100,000 policy, maybe he would want to get a million dollar policy. Then a million dollar policy will probably cost 10 times more, it would cost $10,000 to have that policy. If you view it from that way, in order to protect his other assets, his cost of business would be higher just because he happens to have other things. Bill might argue, "Hey that wouldn't be fair." It would again be a reason why someone with assets would be less inclined to start another business which may not be great for society. Then the other thing that Bill might argue is that look, in exchange for limited liability he might have to be double taxed and this is an interesting discussion here because you'll probably hear this term a lot, double taxation. It's not necessarily going to happen but if it's a large corporation, the type of corporations that are publicly traded this will happen. The idea behind double taxation, it's not true for all corporations. In fact, let me differentiate it, double taxation happens with a C corporation, a C corp. It does not happen with things called S corps and I'm not going to go in detail here in what this are. S corps, LLC which stands for limited liability corporation, LP which stand for limited partnerships or limited liability partnerships, LLPs. It doesn't apply to any of these things but what happens in double taxation, is let's say you have some corporation, some C corp. Let's say that it makes $1,000 in profit. It makes $1,000 in profit in a given year. Since this is being treated as kind of a legal entity that's kind of like a person by the government, it gets taxed like a person. They're going to have to pay some tax. Maybe it's let's say 30% tax. They're going to have to pay 30% or 35% or whatever the corporate tax, the marginal corporate tax rate for this corporation is going to be. They're going to have to pay $300 in taxes. Then let's say this corporation, whatever it has left over after taxes so this is, let me make it clear, this is pretax. Pretax profit it pays 30% to the government and so it has $700 in net, net income. This is net of taxes and everything. Let's say it then dividends that out to its shareholders, so then it gives it to its shareholders. Let's just say for simplicity there's one shareholder. This is true even if there were more than one shareholders. That one shareholder, he's getting $700 in income based on the fact the he owns this corporation. He is going to have to pay taxes again. That's $700, so he has to pay taxes. Let me do it this way, let me draw it. He has to pay taxes again, maybe his marginal tax rate is another 30%. He'll have to pay 30% to the government again. This is 30% on the $700, so he'll pay 210. $210 in taxes to the government based on this net income from his dividend that he's getting out from the C corporation. Actually I want to be very careful here, I don't want to get into the details but dividends can sometimes be taxed differently then straight up income. Just for the sake of simplicity let's say it's 30%, it might be a lower or higher amount. This is the idea of double taxation, the corporation is used as legal entity, it pays taxes, and then after those taxes it's able to give its money back to shareholders and then those shareholders have to pay money on that income again. That's what the double taxation is. Some people say, "Hey this is horribly unfair." "Why should we have to pay taxes twice" "on the same money?" Then someone would argue, "Well look," "your're getting all of this limited liability." "If you don't like paying those double taxes" "don't set up a corporation" "and then just accept the full straight up liabilities." It's a trade off, you pay the double taxes, you get the limited liability. Let me be clear here, This applies mainly the large corporations, if you want the limited liability but you don't want to have to do this double taxation any of these other corporate structures are available. These are usually available to smaller, less complicated companies I should say than what's going on with the C corp. An S corp, you have a limited number of shareholders. LLCs, they can't last forever. They stop lasting as soon as one of the partners of the corporation, one of the owners of the corporation pass away or declare bankruptcy, so there are limitations here. These do get the benefits of limited liability and the profits get pass through to the owners without getting taxed first. They also have single taxation. Going back to the fairness issue, if Bill was smart when he started this company he probably would set this up as a limited liability corporation or as an S corporation or something where he doesn't have to get double taxed and still he would avoid having to pay the soccer player the full million dollars. Just whatever the company has that's all the soccer player would get. Let's say the car service becomes huge and he wants to make it public one day then he would have to make it a C corporation and then he would have to do the whole double taxation. It's something to think about, it's interesting to think about, is it fair to have something like this? The pro-corporation side is it encourages entrepreneurship. People won't worry about the downside as much. It kind of levels the playing field regardless of however many side assets you have, you have the same liability for a certain amount of business. There's usually certain rules that you have to have a certain amount of money in the corporation, a certain amount of insurance in the corporation If you don't then possibly the court can go after the owner's assets. As long as you maintain it in a responsible, well capitalized way, probably won't. Then the other trade-off is this double taxation thing. That at least for large corporations, the general electrics and the Google's and the Microsoft's of the [world] they do pay a fee for this limited liability and that's in terms of this double taxation. Although smaller corporations right when they're getting started out or kind of partnerships, they don't have the double taxation but they do get the limited liability.