Main content
Course: Finance and capital markets > Unit 4
Lesson 2: Corporate taxationIs limited liability or double taxation fair?
Thinking about whether limited liability or double taxation is fair. Created by Sal Khan.
Want to join the conversation?
- 1)LLC = limited liability COMPANY. 2) If limited liability is the justification for double taxation then why allow limited liability for passthrough entities, i.e., LLCs, LPs, etc.? Since passthroughs get the same limited liability corporations do, that can't be the justification for double taxation. What is the justification then? Access to public capital markets. The only significant thing a c-corp can do that a passthrough cannot is sell shares to the general public on a stock exchange.(14 votes)
- Access to public markets is one more reason, but that doesn't mean that limited liability isn't. In general though I think that the link between public markets and limited liability remained largely unexplored in this video (eg. it would be almost impossible to raise money from the public if there weren't some form of insurance for that public against losses of more than the amount invested). So the two are very interconnected.
Also keep in mind that limited liability being allowed for passthrough entities is a relatively more recent development, forged by political and market forces, thus -as limited liability in general- does not need any deeper justification other than that "the majority of politicians voted in favor"!(6 votes)
- When a LCC corporation goes bankrupt. Does that affect the owners credit?(7 votes)
- If you open an LLC it will not show up on your credit report because you are not personally responsible for the business's debts. The business exists as an entity all on it's own.(9 votes)
- What is the advantage of opening a C-Corp over an LLC? I understand a corporation becomes a C-Corp after it becomes larger, but for what reasons?(6 votes)
- They have different tax consequences, mainly. An LLC is not allowed to have more than a certain number of shareholders.(4 votes)
- 6:30, don't corporations pay taxes on their revenue and not just on their profit? And that's before they pay the tax so by pre-tax profit, does Sal mean Revenue?(2 votes)
- No, corporations do not pay taxes on revenue rather than profit. They pay on their taxable income. Same as individuals, really.(6 votes)
- Some people say USA churches aren't taxed because of double taxation. Why aren't USA churches' property/income taxed for reals?(3 votes)
- Double taxation is not why they aren't taxed. They aren't taxed because supposedly that would interfere with the free practice of religion, and they don't have any "profits" because they are "non-profit".(3 votes)
- Can one use personal funds to finance the establishment and operations of a business corporation? If yes, are those funds deductible from taxable income? begging for a response please... thx!(1 vote)
- You can use personal funds to invest in start-up businesses. More ways are being developed every day, Suggest you visit Investment web sites for answers. Be aware! These are very risky investments! Tax deductions are allowed only to the extent of losses.(2 votes)
- Shouldn't the soccer player have carried disability insurance, since his foot is worth a million?(1 vote)
- It can be wise to insure yourself. For example, I believe most surgeons insure their hands in addition to obtaining general disability insurance. But this video is showing what's possible, rather than what is most wise.(2 votes)
- What is the difference between an S-Corp, LLC, LP and LLP?(1 vote)
- If the corporation is allowed to act like a person, shouldn't it have to pay taxes like a person on the same terms(33% of all income to govt)?(1 vote)
- No because the shareholders in the corporation will pay taxes when dividends are distributed (double taxation). So by the time the owners see any money they have, in theory, paid for the privilege of having their business as a separate legal entity with limited liability (i.e. being allowed to have their corporation "act like a person").(1 vote)
- how does an LLC differ from corporation?(1 vote)
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.