Solving Legal Problems with Determination & Integrity for over 30 Years
If you're incorporating your business and you're counting on limited liability, you should know about a legal doctrine called alter ego liability. If you've already incorporated, you still need to know about it and keep it in mind.
In a nutshell, a court can find that a shareholder of a corporation is the alter ego of the corporation; that is, they are one and the same, so the shareholder is liable for the corporation's debts. What! How can that happen? We need to begin at the beginning.
Filing articles of incorporation with the Secretary of State is only the first step. Finishing the job requires the appointment of directors by the incorporator, his resignation, and a meeting of the directors at which they elect officers and pass resolutions adopting bylaws, approving the form of the corporation's stock certificates, and authorizing the sale of stock, to name a few. Then the officers issue the stock certificates in exchange for their sales price, open a corporate bank account, and put the money in the corporate account.
As you might guess, filing the articles without doing the rest of the steps is a good way to invite an allegation that you - the shareholder or holders - are the alter ego of the corporation, which as a result of your carelessness allegedly has only "bare legal existence" and should be ignored. The more of the steps you take, the less likely an alter ego finding will be. Actually issuing the stock certificates, instead of leaving them blank and in the minute book, is particularly important.
And then there's the amount paid for the shares. If we're talking about incorporating before you start the business, the amount will typically be paid in cash. If we're talking about incorporating an existing business, the amount will be the value of the business. Corporations are legally required to be adequately capitalized. There's no set amount, but it probably should be at least what it costs to run the business for a month or two. Paying only $100 for all the issued shares is asking for trouble. Incorporating a business that's not making money is also asking for trouble.
Even if you've done everything correctly to bring the corporation into complete legal existence, you're still not safe. Don't throw the minute book in a drawer and forget about it. Standard bylaws require annual meetings of the shareholders and directors, with written minutes. Don't worry - in practice that's easy to do. If everything's done by unanimous consent, actual meetings aren't necessary, and you can use a form.
It's critical that you don't treat the corporation's bank account as your personal piggy bank. Salaries should be set and paid regularly. Don't pay your kids' orthodontist with a corporate check. Know the difference between capital contributions to the corporation and loans to the corporation, and document them properly.
Lastly, make sure all of your customers know that they're dealing with a corporation, not with little old you. Get cards with the corporation's name displayed more prominently than your name, and always put your title after your name. Sign purchase orders and contracts the same way. And if you can avoid it, don't personally guaranty corporate obligations. If you do, from a limited liability viewpoint, you may as well not have incorporated.
If the above steps are not taken to correctly function as a legitimate corporation, if adequate corporate records are not kept, stock certificates are not issued and corporate funds are comingled with shareholders funds, - a court may decide that your corporation is a bogus legal entity hiding behind a corporate veil. In this case your corporate identity may be disregarded by both the court and the IRS holding the shareholders liable for the corporate debts and consider corporate profits as shareholder income without the benefits of liability protection or corporate tax benefits. This is known as piercing the corporate veil.
