Maintain corporate formalities
By Paul Rovella and Koren McWilliams
Lombardo and Gilles
Many small business owners choose to incorporate their company to protect their personal assets from being reached by their company’s creditors. This protection from personal liability only continues if the owner (or shareholder) takes the necessary actions to maintain the corporation as being separate and distinct form the individual shareholders.
Maintain corporate formalities
By Paul Rovella and Koren McWilliams
Lombardo and Gilles
Many small business owners choose to incorporate their company to protect their personal assets from being reached by their company’s creditors. This protection from personal liability only continues if the owner (or shareholder) takes the necessary actions to maintain the corporation as being separate and distinct form the individual shareholders.
A shareholder must respect the separate existence of the corporation and follow business practices and procedures known as “corporate formalities” both during the formation of the corporation and throughout its existence. If corporate formalities are neglected, then a creditor of the corporation can sue both the corporation and the shareholders and ask a court to “pierce the corporate veil” and make the shareholders personally liable for the corporation’s debts.
Ordinarily, a corporation is considered a separate legal entity from its shareholders, directors, and officers, with separate liabilities and obligations. A court must determine that the corporation is (i) so influenced and governed by a particular person or persons that the separate personalities of the corporation and the particular person is united as one and no longer separate, and (ii) the facts must be such that to treat the corporation and the particular person as separate would allow fraud to occur or promote an injustice. Courts have called this the “alter ego” theory of liability and have used it to determine whether the corporation is, in essence, the “alter ego” of the owner.
Courts look at a variety of factors to determine whether the corporate veil should be pierced. These factors include: (i) commingling of funds and others assets; (ii) the failure to segregate funds; (iii) the unauthorized diversion of corporate funds or assets to uses other than corporate use; (iv) the treatment by an individual of the corporate assets as his own; (v) the failure to obtain authority from the state and federal government to subscribe to or issue stock; (vi) the failure to maintain minutes or adequate corporate records; the failure to adequately capitalize the corporation; and (vii) any other activities which indicate that the shareholders treated the corporation’s assets as their own personal assets.
Undercapitalization is the most common factor argued in veil piercing cases. This means that the corporation does not have sufficient money to cover its debts. Many companies start off being undercapitalized because the owners have underestimated the true start up costs of the business. This risk can be reduced, however, by creating an accurate operating budget for the first 12 months of operation. As a general rule of thumb, a corporation should be capitalized with enough money to cover the first 3 to 6 months of operations, which will depend upon the specific facts.
Another corporate formality that many business owners overlook is keeping corporate funds separate from personal funds. Mixing the funds of the corporation and the shareholders significantly increases the likelihood that the separate existence of the corporate entity will be disregarded.
An additional formality to properly maintain a corporation is the scheduling and holding of regular meetings, including an annual shareholders’ meeting and an annual board of directors meeting. The bylaws of a corporation will often dictate when such meetings are to be held, and many bylaws require that they be held on the same day. All decisions made at any such meetings, in addition to those that affect the general course of the business, should be documented by written corporate minutes that are signed by the secretary of the corporation. In California, corporate minutes are required by law to be kept on an annual basis and may provide evidence of the separate existence of the corporation. In addition to decreasing the chances that a court will pierce the corporate veil in lawsuits, minutes also may need to be produced for an Internal Revenue Service audit or for other government inquiries.
These are the key factors that a court will use to determine whether a corporation was kept separate and distinct from its shareholders. Owners should follow these simple maintenance procedures to minimize the likelihood that they would be held personally liable for the debts and obligations of the corporation.
This column is the work product of Lombardo & Gilles, LLP, which has offices in Hollister and Salinas. Paul Rovella and Koren McWilliams are attorneys for Lombardo & Gilles, LLP. Mail your questions to Koren McWilliams, It’s the Law, c/o The Pinnacle, 380 San Benito St., Hollister, CA 95023.
