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Tax Structure and Liability of Corporations

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  • 0:07 Corporations
  • 1:31 Double Taxation
  • 2:19 Limited Liability
  • 4:49 Piercing the Corporate Veil
  • 6:40 Lesson Summary
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Lesson Transcript
Instructor: Ashley Dugger

Ashley is an attorney. She has taught and written various introductory law courses.

A corporation is a complex business structure with unique characteristics pertaining to taxation and liability. The advantages of a corporation are subject to certain rules. This lesson explains double taxation, limited liability and piercing the corporate veil.

Corporations

One of the oldest and most popular business structures is the corporation. A corporation is a complex business structure, subject to many rules and laws. It's a business entity that is completely separate from the individuals that run the business.

This means that a corporation is, essentially, a legal person. The corporate person is separate from its shareholders, directors, officers and employees. Note that the owners of a corporation are known as shareholders. The shareholders each hold stock in the corporation.

Like any other person, a corporation has certain legal responsibilities. A corporation can sue and be sued. It can make contracts and is liable for those contracts. It can commit a crime or even be the victim of a crime. Corporations can even own property.

The corporate structure has several unique attributes. Corporations and shareholders are subject to double taxation, but shareholders enjoy limited liability. However, corporate advantages aren't absolute. Corporations must follow strict rules or the corporate veil will be pierced. Let's take a separate look at these corporate attributes.

Double Taxation

The main disadvantage of a corporation is that the business is separately taxed on its profits. This tax treatment differs from partnerships or sole proprietorships.

Since corporations are considered to be a separate legal entity, that entity is subject to taxes just like other individuals. Ultimately, this leads to double taxation because income taxes are paid twice on the same source. Keep in mind that the corporation's profits become the shareholders' salaries, bonuses and dividends. This means that business profits are taxed as earned income both when received by the corporation and also when passed on to the shareholders.

Limited Liability

Now let's look at an advantage provided by the corporate structure. The main advantage of a corporation is that it provides shareholders limited liability. Since the corporation is an independent entity from the shareholders, the corporation is held legally liable for its own business debts, taxes, liabilities and other obligations. The shareholders enjoy limited personal liability for the financial obligations of the business.

This means that the shareholders generally can't be held personally liable for the corporation's contracts, debts, court judgments or any other financial obligation of the corporation. Because only corporate assets can be used to pay the corporation's liabilities, each shareholder risks losing only the amount of money that shareholder invested in the corporation. This doctrine serves to protect the shareholders' personal assets, like cars and houses.

Limited liability, however, is not absolute. There are several circumstances in which limited liability won't apply. A shareholder can be held personally liable if the shareholder:

  • Personally injures someone
  • Individually guarantees a debt
  • Fails to deposit taxes withheld from employees' wages
  • Engages in fraudulent or illegal behavior

For example, let's say that Carla is a shareholder in Company, Inc. Carrie is the president at Company, Inc. and Carla's best friend. Sadly, Company, Inc. isn't doing very well. Carrie fears the business might be forced into bankruptcy in the next few months. Carrie says the business needs money to pay bills, but she can't get a business loan because Company, Inc. has bad credit. Carrie asks Carla to guarantee a loan for Company, Inc.

Carla co-signs the business loan, but unfortunately, Company, Inc. goes out of business anyway. When the bank tries to collect on its loan, Carla won't be able to claim the protection of limited liability. Carla's personal assets can be seized in order to pay back the loan.

Piercing the Corporate Veil

Note also that shareholders can be held personally responsible for the corporation's liabilities if the shareholders fail to treat the corporation as a separate legal entity. The result is known as piercing the corporate veil and can occur by court order when one or more shareholders treat the corporation as personal property.

A court can order that the corporation fails to exist as a separate entity, thereby subjecting the shareholders to personal liability. The corporate veil can be pierced, or broken, when the shareholders fail to keep a strict separation between the company and its shareholders. Common piercing acts include the failure to:

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