Post by Steve O’Donnell of 3C Patent Law
Most small businesses have some idea about how organizing their business can reduce their liability. Many choose to either file their own corporate paperwork with the state or use one of the many pseudo-lawyer incorporation services available online or found in the “legal documents” section of an office store to save money. Granted, often the actual paperwork is not terribly complicated for a small business, but what these small business owners are missing out on is legal advice that they desperately need to ensure that their corporate identity survives an attack.
When properly filed and operated within certain parameters, corporations are considered to be separate entities. If a corporation does something that exposes it to liability, the corporation is the entity that takes the hit, the owner doesn’t have their personal assets on the line.
Consider this scenario: someone forms a corporation and goes out of town to present the business’s wares at a trade show. On route there is a car accident. Is the business liable for the accident or is the business owner personally liable? Similarly, consider what can happen if someone is harmed by a product the business sells; is the corporation he only entity liable or can the harmed product reach through to the owner’s personal property for compensation?
Generally, in either instance, the corporation is liable as a separate entity and the owners’ personal assets are unavailable to compensate a harmed party, however that isn’t always the case.
The act of setting aside the liability shield that a corporation provides is called “piercing the corporate veil,” and is more common than those selling incorporation kits care to mention. In fact, I’ve never encountered a corporation set up in such a manner that wasn’t at a high risk of losing its separate identity.
In Pennsylvania, there is a presumption against piercing the veil. In other words, it’s not an action a court takes lightly and, absent strong evidence to the contrary, the corporate shield will remain intact. That isn’t to say that it doesn’t happen. In fact, unless a harmed party is able to recover their damages entirely from the corporation one can be assured that an attempt to pierce the veil will be made.
The factors that a court will look at include: whether the corporation was sufficiently capitalized, whether corporate formalities were followed, whether there was a substantial intermingling of corporate and personal affairs, and whether the corporate structure was used to perpetuate a fraud. No single factor is normally going to be dispositive, although it can be.
The first two factors are usually tightly intertwined and many small corporations are under capitalized because there is such pervasive intermingling to personal and corporate affairs. In other words, many owners don’t treat the corporation like a truly separate entity. Some actions that can endanger the business owners along these lines include paying company debts out of a personal account, paying personal debts out of the corporate account, or keeping only a minimal amount in the corporation’s accounts. Also, it’s tempting to claim deductions for things purchased on a corporate account even when those things are destined for home use. All such actions are going to weaken the corporate shield.
Another common problem is that many small businesses, especially those with a single owner, completely ignoring corporate formalities such as holding meetings, keeping good records, having business plans, and conferring with tax or regulatory professionals as needed. It sounds silly that a corporation owned by a single person needs periodic meetings to discuss plans, but it should be done, even if there is only one person wearing all the hats, and detailed notes of these meeting should be retained. Lastly, some decide to form a corporation for nothing more than liability protection in the mistaken belief that doing so means that they can be save money on the appropriate insurances.
Those actions, alone or together, can lead a court to “pierce the corporate veil” and hold the owner personally liable for the debts of the corporation. If that happens, the initial money saved by foregoing appropriate legal advice and relying on an incorporate-yourself set of forms results in an anemic corporate form that gets brushed aside and the owners’ personal assets are available to compensate a harmed party. In such a case it’s probably better to have never formed a corporation since then the owner wouldn’t have the additional legal expenses from trying to defend an attack that the corporation won’t survive.
There are huge benefits to incorporating your business, make sure you take advantage of them.
Find other great blog articles for small businesses on Steve’s C3 Patent Law blog.