Introduction and Overview
Principal Characteristics of a Corporation
Limited Liability

A corporation is a state-approved and state-regulated legal entity.  A corporation is formed by filing Articles of Incorporation (referred to in some states as a “Certificate of Incorporation”) with the appropriate state agency, typically the Secretary of State.  A corporation is owned by its shareholders and is managed by its board of directors.  Every corporation must have at least three Officers: a president, chief financial officer (treasurer) and secretary, though one person may occupy more than one office.  In most states (e.g., California), one person may be the sole director, sole officer and sole shareholder of a corporation.

Those who run the corporation must observe corporate formalities.  Annual stockholder's meetings must be held, minutes of the meetings must be maintained, officers must be appointed and stock must be issued to shareholders.  Most importantly, the corporation must keep adequate financial records and must separate the financial transactions of the corporation from the personal transactions of the shareholders and officers.

• A corporation may be created only by permission of each state government.

• A corporation is a legal person and a legal entity existing independently of its owners (called shareholders) and its managers (the board of directors and officers).

• The “independent legal entity” status has several important consequences:

• One of the major advantages in forming a corporation is that its shareholders enjoy limited liability.  With few exceptions, they are not liable for the debts of a corporation beyond their own capital contributions – even if there is only one shareholder.

  A thorough discussion of limited liability appears below.

• A corporation pays state and federal income taxes on any profits, or net income, existing at year-end.  If these profits (after taxes) are then paid to the shareholders in the form of dividends, they are taxed again to the shareholder as dividend income at the shareholders’ individual tax rates.

  This "double-taxation" is a potential drawback of forming a corporation, though common methods exist for eliminating or substantially reducing double taxation.

• One method is to distribute profits to a shareholder-employee in the form of salary, typically as a year-end bonus.  This reduces the corporation’s net profit (taxable income) and “shifts” the payment of the tax on this income to the shareholder-employee on his personal tax return.

• Another method is to elect “S” corporation status, which automatically results in the taxable income of the corporation being “passed through” to the individual shareholders in proportion to their percentage ownership interests, with the tax being paid by the shareholder(s) on their personal tax returns.

• The life of the corporation is unaffected by the retirement or death of its shareholders, directors, and officers.  Corporations are therefore perpetual unless some action is taken, either by the shareholders (dissolution, merger, etc.), or by the state (suspending or forfeiting corporate rights if the corporation fails to pay taxes or satisfy certain other ongoing legal requirements).

• A corporation may sue and be sued in its own name.

• The “legal person” status also has several consequences:

• A corporation, under the Constitution of the United States, is guaranteed due process and equal protection of the law.  It also has free speech rights.

• A corporation has its own domicile and its own place of residence, whose locations determine in part whether a state may constitutionally subject the corporation to its laws.

• A corporation may acquire, hold, and convey property in its own name.  It may also enter into contracts.

• Generally, ownership in a corporation is freely transferable.  A shareholder may sell his shares (ownership) to whomever he wants, and the purchaser becomes a shareholder with the same rights the seller had.

• Generally, a shareholder owes no fiduciary duty to the corporation.  A shareholder who is not a director or officer may deal with the corporation as may any other person.  A shareholder may be a creditor of a corporation. 

Limited Liability

A major advantage of the corporate form of organization is its ability to shield its owners from individual liability.  Proper formation and operation of a corporation limits the shareholders’ liability by preventing the corporation’s creditors from reaching the personal assets of the shareholders to satisfy the corporation’s debts and liabilities.

Under certain circumstances, however, a court may “pierce the corporate veil” and hold shareholders personally responsible for corporate debts.  Under the “alter ego” doctrine, a court will determine whether the shareholders’ use of the corporation perpetuated a fraud or injustice; that is, whether the corporation has been operated as a mere shell for the purpose of allowing the shareholders to avoid personal liability.  Essentially, a court must find that an injustice would result to a party unless the court disregards the corporate form and holds the shareholders personally liable.

In California, a landmark case reviewing this legal doctrine was Associated Vendors, Inc. v. Oakland Meat Co. (1969). The appellate court stated the general rule for disregarding the corporate form as follows:

“The general rule is thus stated as follows: 'Before a corporation's acts and obligations can be legally recognized as those of a particular person, and vice versa, it must be made to appear that the corporation is not only influenced and governed by that person, but that there is such a unity of interest and ownership that the individuality, or separateness, of such person and corporation has ceased, and that the facts are such that an adherence to the fiction of the separate existence of the corporation would, under the particular circumstances, sanction a fraud or promote injustice."

• The Disregard of Legal Formalities. In short, courts will review whether or not the corporation was properly formed beyond the simple filing of articles of incorporation to create the existence of the corporation. While there is some variation in the legal requirements among the states, the common requirements include most of the following:

• Filing Articles of Incorporation with the Secretary of State (or appropriate state agency)

• Issuing stock – to show shareholder ownership of the corporation. 

• Opening a corporate bank account – to ensure the separateness of personal and corporate assets and financial transactions.

• Filing of any required “statement of officers” with the Secretary of State (or equivalent state agency).

• Complying with other incorporation requirements of a particular state, such as publishing notice of the filing of articles of incorporation in a local newspaper.

• Failure to Obtain Authority to Issue Stock, and To Issue Stock. The ownership of a corporation, from a single “owner” corporation to the largest publicly traded corporation, is evidenced by the issuance of shares. While this may be done electronically in public corporations, in private corporations it requires the completion of individual share certificates for each shareholder. Further, shares in all corporations constitute “securities” under both federal and state securities’ laws. All corporations must comply with the requirements of such laws to obtain approval from, or provide notice to, the appropriate governmental agency for the issuance of shares. In addition to incurring fines or penalties for failure to comply with such laws, a corporation will be adding a factor to be considered by the courts if a creditor requests a court to hold the shareholders personally liable for the corporation’s debts and obligations.

• Failure to Adequately Capitalize the Corporation; Absence of Assets. When an individual forms a corporation, thereby creating a separate legal entity, the corporation typically receives assets in the form of contributions made by the initial shareholders in exchange for their respective ownership interests in the corporation. If the business was in existence prior to being incorporated, perhaps as a sole proprietorship, there probably are already assets to be transferred to the new corporation. These might include accounts receivable, cash in bank accounts, equipment, office furniture and the like. If none of the assets of an existing business were transferred to the corporation, or a start-up business that incorporated had no corporate assets, this factor will weigh heavily in a court’s decision to impose personal liability on the shareholders.

The more common example is where a corporation has been capitalized with “some” assets, but the concern is whether the capitalization is sufficient to satisfy this alter ego factor. This is always a case-by-case analysis since there is no one minimum amount that is considered sufficient for every type of business. Each corporation must evaluate its anticipated business risks and potential liabilities and the magnitude of claims that might reasonably arise in conducting the type of business in which the corporation is involved. Insurance coverage is a very important part of this evaluation since the availability of insurance proceeds decreases the amount of assets that the corporation must have on its own to meet this sufficient capitalization test.

For an owner of a small stationery store, the largest risk may be of injury to someone while shopping in the store, a risk typically covered by insurance. Risks involved in simply selling products may be small in both the types of claims and the amount of financial exposure. Here, the amount of capitalization needed to be “sufficient” may be quite small beyond customary liability insurance for customer personal injuries on the premises.

For a general building contractor, the financial risks would be much greater. Defective construction may lead to substantial claims for property damage and even personal injuries. Even with available insurance, there may be substantial deductibles to be paid by the contractor. The level of capitalization and assets required for this corporation to satisfy the “sufficient” capitalization requirement will be much higher than for the owner of the stationery store.

• Failure to Maintain Minutes or Adequate Records. A primary method for recognizing the separateness of the corporation from its owners is to document the actions of the corporation in written minutes. The corporate officers too often neglect this ongoing responsibility. The reasons for this are many. There are typically few, if any, state corporation laws setting forth the types of events that must be documented in corporate minutes, and this may mistakenly be interpreted as the absence of any legal requirements. As the Associated Vendors case indicates, the courts in evaluating the alter ego liability of the shareholders will certainly consider this factor.

In addition to corporate minutes, it is important for a corporation to maintain other types of records. If loans or other financial transactions occur between the corporation and its officers or shareholders, these should be documented in writing with promissory notes or other appropriate documents or instruments. The financial transactions of the corporation must be reflected in financial records, bank account statements and other bookkeeping documents as well as corporate tax returns.

• Commingling of Personal and Corporate Funds and Assets. One of the most common mistakes made by start-up corporations or sole proprietors who incorporate their business is to commingle, or combine, their personal assets with those of the corporation. As a sole proprietor, there is no legal or tax distinction between the individual and the business—they are considered one and the same. If the sole proprietor wants to have both personal and business income and expenses combined into one checking account, it is not improper to do so.

When a business operates in a corporate form, it is imperative that the corporation has its own bank account and that only income and expenses of the business are transacted in corporate accounts. There are many ways in which this separateness may be violated between the corporation and its shareholders, including the following examples:

• Writing checks from the corporate bank account to pay for purely personal expenses (e.g., vacation expenses, mortgage payments on a home, personal income taxes);

• Using the corporate credit card to pay for purely personal expenses (e.g., theatre tickets, jewelry.);

• Using funds of one corporation to pay the expenses of a separate business

• The Holding Out By An Individual That He Is Personally Liable For The Debts Of The Corporation. This sounds like something that would never be done since one of the primary reasons for incorporating is to receive limited liability protection for one’s personal assets. However, this can occur with both intentional and unintentional conduct.

The classic example of how this occurs unintentionally is with the signing of documents. Let’s say that Paul Prescott is the sole officer, director and shareholder of a corporation, Paul’s Printing, Inc. and the main contact with customers and vendors. Paul leases a new printing press from Printing Presses of America (“PPA”). The equipment lease does not mention Paul’s Printing, but shows that the printing press is being leased to Paul Prescott and Paul Prescott signs the lease. Paul is unable to make the lease payments for several months and PPA files suit against Paul Prescott individually.

Paul argues that this is an obligation of the corporation, not his personal obligation, since the printing press was for the corporation’s business. If PPA did not know that Paul’s business was a corporation or otherwise reasonably believed that this was his personal commitment to lease the printing press, there is a good probability that Paul will not be able to use the corporation as a shield from this obligation since he held himself out as being personally liable for the payments on the printing press lease.

Now let’s change the facts slightly so that the equipment lease was prepared in the name of Paul’s Printing, Inc., but the lease was simply signed by “Paul Prescott.” This creates a less clear situation: was Paul intending to sign the lease in his personal capacity and be personally responsible for the payment obligations, or was he signing the lease on behalf of the corporation? To avoid such an unintentional result, all documents signed by an officer on behalf of the corporation should always be signed in a representative capacity, that is, it should clearly indicate that the individual is signing the document as the president of the corporation or other authorized officer and not as an individual.

The intentional holding out by an individual that he is personally liable for the corporation’s obligations is more akin to fraud or misrepresentation. It might occur where the corporation has no assets and is essentially “judgment proof.” To exploit this fact, the principal officer-shareholder has a creditor prepare an agreement in the name of the corporation but states that he will personally take responsibility for the payment of the obligation. When the corporation defaults, the creditor will have a strong case for convincing a court that the corporation should be disregarded and the shareholder should be personally liable since the creditor relied on the representation of the shareholder in entering into the transaction.

To recap, there are many ways in which the limited liability protection can be jeopardized by improper corporate practices. Since many of these pertain to the specific responsibilities involved in the formation and initial setup of the corporation it is crucial that the small business owner have assurance that a competent professional is involved in the incorporation of his business.