Court Tomorrow … and a Primer on Business Entities

June 29, 2014

Two cases await decisions at the Supreme Court for this term, Burwell v. Hobby Lobby and Harris v. Quinn. Hobby Lobby should address whether a for-profit corporation can have religious beliefs which it can express in the context of an Affordable Care Act provision which requires that health insurance policies include contraception benefits, where the corporation need not purchase insurance for its employees. Think I loaded the deck? Really, I didn’t, for this is the fact-pattern associated with Hobby Lobby and its companion cases.

Harris involves an Illinois statute that affects whether home health care workers must join a union, where the state pays those people through Medicaid. Hard to imagine the Court not finding the law unconstitutional, given the course of labor union jurisprudence over the past 20+ years.

In the Hobby Lobby oral argument Chief Justice Roberts alluded to Subchapter S corporations once, actually using the term “this type of Chapter S Corporation that is closely held.” The off-hand comment has generated a decent amount of copy, to none of which I cite here. Instead, I’m using the comment as an opportunity for a brief, teachable moment about business entities.

There are four basic business entity forms, to wit:  (1) sole proprietorships; (2) partnerships; (3) corporations; and (4) limited liability companies, or LLCs.

If Frank Franks owns Frank’s Frankfurters as a sole proprietor, he uses his Social Security number for reporting his workers’ wages and paying payroll taxes, he reports income and expenses on Schedule C, and if someone gets a bad dog and gets sick, he’s personally liable. (Better buy insurance, Frank Franks!)

If Frank Franks takes in a partner, Dave “Doggy” Dodger, they have a partnership. Now they need an Employer Identification Number (EIN) for wages/payroll tax matters, they have to file a Form 1065 Partnership Tax Return, and if someone gets sick on account of a bad hot dog—I expect they’re probably called Dodger Dogs by now—they’re both still liable, and we all hope Doggy didn’t tell Frank insurance is an extravagance.

Assume Frank and Doggy figured it all out about 20+ years ago. They would have formed a corporation. Now, they still need an EIN and the corporation is a separate legal entity, which must pay taxes on earnings. Frank and Doggy can pay themselves reasonable salaries, and those and other business expenses get deducted from revenues; the corporation pays income tax on the difference. Oh, and Frank and Doggy, as shareholders of the corporation, have no liability for the bad hot dogs. The corporation should still be insured, for it has assets and income, but owning the business through a corporation provides liability protection for Frank and Doggy. (I digress here, for a moment, to offer smart thinking about why Hobby Lobby’s claim lack merit, under established principles of corporate law. Here’s Symposium: Under a straight-forward reading of constitutional text and history and fundamentals of corporate law, Hobby Lobby’s claims fail, posted at SCOTUSblog by Elizabeth Wydra on February 27, 2014.)

Back in the day, if Frank and Doggy operated through a corporation, they might have filed Form 2553 with the Internal Revenue Service, electing to be a Subchapter S corporation. No state law changes regarding liability protection or anything else, but profits in excess of salaries would be treated as Subchapter S distributions, taxable to Frank and Doggy on their individual tax returns. The S election allows a company with profits to have them taxed once at the shareholder level; however, there are limits associated with which entities can make the S election. Generally, it’s for corporations owned by individuals who are U.S. citizens. Certain trusts, estates, and partnerships can also qualify.

Now, assume Frank and Doggy are starting out now. Today, they would almost certainly use an LLC, as opposed to a corporation. They get the liability protection and most everything else the corporation offers, but should still buy insurance. They get the “profits pass through” associated with partnerships and Subchapter S corporations, without the citizenship and entity limitations that come with the S election. They also avoid annual reports, and lots of formalities associated with corporations. Absent a likelihood that a corporation will register its stock and sell interests to the public—not an everyday occurrence—there is little reason to form a corporation today.

So, back to Hobby Lobby. When the Chief Justice referred to “Chapter S Corporations” it seems likely that he was referring to businesses, large or small, that have a limited number of owners. Most observers, me included, think he was saying a corporation with a few owners should have the right to hold the religious beliefs of its owners, while IBM and Exxon should not. Almost certainly, he was not intending to have the way in which a corporation deals with its taxable gain affect its right to have and act on its religious beliefs.

Note:  You have received the business organizations overview. Every situation differs, and time and space limit my ability to account for every possibility. If you have business organization issues, get help, and do not rely on this post for legal advice.



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