When you buy a new refrigerator, you get an owner's manual
explaining how to avoid problems. You may not get the same kind of
owner's manual when you incorporate your business, but if you
don't follow the rules, you'll run into problems.
Consider this case. The sole owner of a South Carolina oil
company bought the stock of a local insurance agency for $1.5
million. That same day, he sold most of his new agency's assets
to another company for $1.6 million. At the time, the agency had 35
creditors, including one agent due $18,000. When that agent sued,
the owner claimed the debts belonged to the agency. He argued that
because it was a corporation--a separate legal entity--he
wasn't responsible for the debt.
The trial court disagreed. Normally, the law protects
shareholders from the debts of the corporation, but in this case
the court found that the corporation was merely a facade for the
owner's personal activities and functioned solely for his
financial advantage. He had drained the agency of $626,073 for his
family and friends and for his other company, without any invoices,
records or corporate resolutions. He didn't even leave enough
to pay the creditors. When the owner appealed, the Court of Appeals
of South Carolina refused to recognize the existence of the
corporation, so the owner had to pay the debts himself.
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One of the chief reasons for incorporating your business is to
gain protection from its debts. If someone gets hurt or a business
deal goes sour, you don't want each partner to be legally
responsible for the judgment. However, if you incorporate your
business but fail to follow the rules governing corporations, a
court can pierce the corporate veil and hold you and the other
owners personally liable for the business's debts. To protect
yourself, be sure you understand how a corporation is expected to
operate under the law . . . and be careful to follow the rules.
If you've ever been involved in a lawsuit against a
corporation, you might wonder why the law protects corporate
shareholders from personal liability. So did many others when the
principle was new. Limited liability is a "mode of
swindling," declared Jeffersonian scholar Thomas Cooper in the
1820s. In effect, Cooper contended that the law allows business
owners to escape responsibility for what their businesses do.
At about the same time, the president of Columbia University
proclaimed that "the limited liability corporation is the
greatest single discovery of modern times." Until 150 years
ago, citizens were so suspicious of corporations that establishing
one required a special vote in the state legislature. Even then,
the corporation could only operate for a limited duration and had
limited allowable purposes.
The reason legislatures allowed corporations to shield their
owners from liability was to encourage business development in
their states. People are unlikely to invest capital in a growing
business if they will be held liable for all business decisions,
especially if they're passive investors with no responsibility
for the daily decisions.
Mom and pop corporations are another story. Typically, the
shareholders are also the people running the business. Should they
be free from liability for the company's debts? To satisfy this
concern, legislatures have established rules that corporations must
follow to be considered separate legal entities. Likewise, over the
years courts have developed certain principles they use to
determine when it's fair to disregard the existence of the
corporation and hold the owners responsible.
If you expect the corporate form to protect you, respect the
corporation as a separate legal entity with its own interests.
That's how two Georgia business owners protected their personal
assets, even after their business failed. The corporation, a
wholesale distributor of frozen fish, owed $51,000 plus interest to
its former national sales director. When the corporation filed
bankruptcy, the sales director convinced a court the business
owners were liable for the debt. However, Georgia's Court of
Appeals reversed the decision.
The appeals court noted that the owners had not abused the
corporate form by assuring the money would be repaid with
fraudulent intent. Further, whenever corporate funds were used to
pay the owners' personal expenses, it was authorized by the
directors as part of the owners' compensation packages. The
corporation also maintained scrupulously separate records.
How do you treat your corporation as a separate legal entity?
First, provide it with enough capital to meet its obligations. When
a so-called corporation has never had enough assets to operate and
pay its creditors, courts are likely to call it a sham.
Next, make sure your corporation observes the formalities
required by state law:
*Keep accurate financial records for the corporation, showing a
separation between the corporation's income and expenses and
the owners'.
- Hold annual meetings to elect officers and directors, even if
they're the same people as the shareholders. Also keep minutes
of these meetings.
- If required, provide an annual report to the proper state
agency.
- Make sure major decisions are made by all the directors, not by
one individual without consulting the others.
- Make it clear that the business is a corporation by having
officers sign contracts and purchase orders in the
corporation's name, not their own. Failure to properly indicate
your corporate capacity may result in personal liability. The
proper way to sign is:
XYZ Inc., by:___________________________
Fred Smith, President
Operating by corporate rules may seem like a nuisance, but
it's the price you pay for protection.
Steven C. Bahls, dean of Capital University Law School in
Columbus, Ohio, teaches entrepreneurship law. Freelance writer Jane
Easter Bahls specializes in business and legal topics.