Best Defense

Will your corporation hold up in court? Only if you follow all the rules.
Magazine Contributor
5 min read

This story appears in the January 1997 issue of Entrepreneur. Subscribe »

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.

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.

  • Legal Principles

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.

  • Observing Formalities

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.

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