One of the principal reasons businesses incorporate is to shield the personal assets of the owners from the debts of the corporation and to limit the shareholders’ liability from claims against the corporation. This limited liability is a function of the corporation’s status under state business corporation statutes as a distinct legal entity, separate and independent of its owners. A corollary of the corporation’s status as a separate and distinct legal entity is the requirement that its shareholders observe the legal requirements appropriate to its status. Where the shareholders themselves disregard the corporation’s independent status, they place themselves at risk of having a court ignore the corporate entity and impose personal liability on the individual shareholders.
One of the challenges for the small business owner who cannot afford an in-house legal staff is to ensure that its business is in fact operated as a distinct legal entity and that it properly adheres to all the corporate formalities to maintain the protection of the corporate form. Presented below are some of the common pitfalls of the small business owner and what you need to do to avoid them.
- Fill Out the Corporate Kit.
Although most incorporation services provide a corporate kit when forming the corporation, it is not uncommon to find the corporate kit for many small businesses sitting unopened and forgotten, collecting dust on a bookshelf, even after the business has been in operation for many years. A corporation that is run this informally is a corporation in name only. Unfortunately, this failure becomes apparent only when a problem arises, such as a challenge to the legality of a corporate act, and at that point the resolution may carry a heavy cost. It is important to begin filling out the corporate book as soon as the corporation is formed and to document important corporate decisions with proper minutes.
- Issue Shares to the Shareholders of the Corporation.
Although this point appears obvious, it is not at all uncommon that small privately held businesses neglect to issue shares to the owners of the corporation, with the result that needless disputes develop as to who the owners of the corporation are when disputes between the principals arise. Accordingly, it is important to issue share certificates to the shareholders, to record the names of the shareholders in the company’s share register, and to document the corporation’s receipt of payment for the shares.
- Open a Separate Bank Account for the Corporation.
As a distinct legal entity, it is crucial to open a separate bank account in the name of the corporation and to keep meticulous records of all transactions. All corporate funds received by the corporation should be deposited in the corporate account. Under no circumstances should the funds of the corporation be commingled with personal funds of the owners or any other corporate entities. This is one of the main factors the courts look to in determining whether to disregard the corporate form.
- Hold Regular Board of Directors’ and Shareholders’ Meetings.
New York’s Business Corporation Law requires at least an annual shareholders’ meeting to elect directors, but permits shareholders to act without a formal meeting on written consent.
- Document All Loans Between the Shareholders and the Company.
If the shareholders make loans to the corporation, or if the corporation makes loans to the shareholders, make sure that these loans are properly documented on the books and records of the corporation, that such loans are approved by the directors and reflected in the board minutes, and that the loan is evidenced by a promissory note that provides for regular payments with interest. In the absence of a promissory note, a shareholder loan may be deemed a contribution to equity, which, in the event of a dissolution, may not be repaid until all other creditors are paid in full. Conversely, loans to shareholders that are not properly documented will create the appearance that the shareholder is disregarding the corporate entity and treating corporate accounts as his personal accounts. Such informal, undocumented loans ignore the existence of the corporation as a distinct legal entity, and may cause a court to ignore the corporate entity as well.
- Pay All Wage Claims, Withholding and Sales Taxes.
It is crucial that the corporation pays all withholding and social security taxes and sales taxes. By statute, a corporation’s shareholders and officers can be held liable for these taxes. Accordingly, it is important that the corporation hire a competent and trustworthy controller or CFO, or at a minimum, a competent payroll company. Similarly, all wage claims and union benefits must be timely paid by the corporation, or the ten largest shareholders may be held personally responsible.
- Always Sign the Corporation’s Legal Documents in Your Corporate Capacity.
All legal agreements entered into by the corporation should be signed by the corporation by a proper corporate officer, with his corporate title clearly indicated next to his name. Contracts entered by the corporation should be clear that it is an obligation of the corporation, and should never be signed without the officer’s corporate title prominently shown, so that it cannot be deemed a personal obligation or guarantee, unless that is what is intended.
