One of the advantages of operating a business in corporate form is the protection a corporation provides to its shareholders from exposure to the corporation’s liabilities. This corporate shield from liability, often referred to as the “corporate veil,” protects a shareholder’s individual assets from claims by the corporation’s creditors.
Protecting the veil requires care and attention. The courts may disregard the corporate veil when it is used by the individuals involved to perpetuate fraud, circumvent a statute, or accomplish other wrongful or inequitable purposes. Equally important, the corporation’s veil can be damaged if the business is not properly organized and carefully operated.
The case law of California and other states requires that shareholders treat the corporation as an entity (a person) separate from its shareholders. The courts look at many factors in making this determination. For example, the courts will look for commingling of funds between the corporation and its shareholders or the diversion of corporate funds to other than corporate uses.
Other important factors considered by the courts are whether or not the corporation is observing proper corporate formalities. The following questions may be asked:
- Was the corporation properly organized?
- Was the issuance of corporate stock properly authorized by the directors and was the stock actually issued?
- Was the corporation adequately capitalized?
- Is the corporation observing legal formalities such as holding shareholder and director meetings and maintaining minutes and adequate corporate records?
Proper organization of a corporation requires more than just filing articles of incorporation. It requires electing directors and holding an initial meeting of directors to elect officers, adopt bylaws, authorize the issuance of stock, and deal with related elections and approvals. It also means adequately capitalizing the corporation and arranging for appropriate insurance coverage.
Proper maintenance of a corporation as a separate entity includes complying with corporate formalities such as holding regular shareholder and director meetings. Those meetings and the actions taken at those meetings should be documented with appropriate minutes or written consents. If meetings are not held, written consents should be executed in lieu of meetings – even if the corporation has only a few shareholders, directors and officers. Indeed, this holds true even if there is only one shareholder, who also serves as the only director and the only officer.
With assistance from professional advisors, maintenance of corporate records need not be a complicated process. Ask your accountant to assist with maintenance of the corporation’s financial records, your insurance advisor to periodically review insurance coverage, and your attorney to assist you with minutes and stock records.
At least once a year – at a minimum – an annual shareholders meeting should be held to elect new or reelect the old directors and an annual directors meeting should be held to elect new or reelect the old officers. These annual meetings should be held even if the directors and officers remain the same from year to year. In addition, directors meetings should be held or consents should be prepared to approve certain other transactions such as loans, leases, and certain contracts.
The Internal Revenue Service may ask to see the corporation’s minutes in connection with an audit. Properly prepared minutes will provide evidence for your treatment of the corporation as a separate entity. They can also back up certain tax elections or the corporation’s tax treatment of particular items of income, deduction or credit.
We find it helpful to meet with a corporation’s officers periodically to discuss the activities of the corporation and the proper documentation of those activities. If a personal meeting is inconvenient, these matters can be discussed by telephone or dealt with in correspondence, facsimile or by electronic mail.
If you have any questions, please contact L. Michael Telleen at firstname.lastname@example.org or (650) 342-9600.