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5 • 2016

The Benefits of Incorporating

In Read This Before Incorporating, I expressed my thought that most businesses incorporated online did not need to be incorporated in the first place.  Incorporating makes sense for some entrepreneurs and not for others.  The key is to evaluate the pros and cons for your specific situation. Since most entrepreneurs we speak with think they have to incorporate or form a LLC, we’ll start with the benefits of business formation.

The principal legal reason[1] to incorporate, and the one most entrepreneurs have in mind when they call us, is liability protection. Every state recognizes incorporation as a perfectly legitimate way for a business owner to seek, in the words of one court, “to limit or eliminate the personal liability of corporate principals.”[2] But the notion of entirely “eliminating” the personal liability of a business owner just by filing incorporation papers is actually quite misleading.

As we recently wrote (Incorporating Does Not Protect You from Your Own Negligence), forming a business entity protects you from some liabilities but not others. For example, incorporating does not insulate you from liability for your own tortious behavior, such as fraud or negligence. So if you are a lawyer, accountant, or other professional looking to achieve protection from liability for your own negligence/malpractice, that is not a benefit available to you by forming a professional corporation.

On the other hand, incorporating does ordinarily protect you from liability on corporate obligations such as contracts or promissory notes.[3] So, for example, if you are in the business of baking and selling cupcakes and you contract to sell 500 cupcakes to the lucky couple on their wedding day but fail to deliver, then your corporation is liable for breaching the contract, and not you individually—that is, your personal assets are not at risk in the transaction. That, of course, begs the question of whether you have any personal assets to protect. If your business is churning out ideas on a laptop computer (rather than cupcakes using expensive baking equipment), the only thing of value you own is that computer, and the business is currently operating at a loss or is only “ramen profitable,”[4] then personal asset protection probably is not a substantial benefit of incorporating at the moment.

If liability protection is the primary benefit you’re after by incorporating, then you also have to be aware of another concept that we’ve written about before: piercing the corporate veil. Under the legal doctrine of piercing the corporate veil, or alter ego, the normal rule of limited liability is upset and the business owner/shareholder is held personally liable for the corporation’s debts based on the court’s consideration of a wide variety of factors.[5] For present purposes, we’ll focus on two of those factors: maintaining corporate formalities and undercapitalization.

As we’ve noted (Reducing Risk of Alter Ego With Some Simple Things), studies have shown that maintaining proper corporate records, such as minutes of meetings, is a simple but effective way to reduce the chances of having your corporation’s veil pierced and liability imposed on you personally.[6] Keeping good minutes does not impose a substantial financial burden on a startup.

Another factor that appears in many alter ego cases is undercapitalization. Studies have also pointed to a connection between piercing the corporate veil and undercapitalization of a new corporation. One of the studies we examined found that in cases where courts noted that the corporation was undercapitalized, in that there was not enough money to fund the business properly from the get-go, the courts pierced the corporate veil in about three out of every four of those cases, whereas the courts pierced in only about one out of every ten cases where that factor was not present.[7] The idea is that courts will not hold business owners liable for corporate obligations, but only where the owners see to it that sufficient capital was made available, at least initially,[8] to pay the corporations’ anticipated debts.[9] Simply put, you can’t start a corporation with no capital and reasonably expect that your personal assets will be protected from the corporation’s creditors.[10]

In short, while liability protection is certainly a benefit of forming a business entity, entrepreneurs are more likely to realize that benefit if they put some time and money into properly maintaining the corporate records and funding the company at an adequate level. In other words, there are some hidden costs associated with achieving the benefit of liability protection; it is not so easy as merely filing incorporation papers with the Secretary of State’s office.

The other main benefit of forming a business entity we see is documenting a deal with partners. A corporate or LLC structure does a great job of formalizing the ownership and roles of the entities’ founders. For example, we’ve noted before (Failure to Issue Stock Certificates Is A Crushing Blow to Liability Protection) that issuing stock certificates is another important step in making sure that you don’t lose out on the liability protection normally achieved by incorporating. But issuing stock certificates also documents the exact ownership percentages in the corporation so that does not become an issue among partners later on. And maintaining the appearance of a properly functioning corporation also includes adopting bylaws, electing directors, and appointing officers, all of which solidifies the corporate structure for governance purposes.[11] In a limited liability company, structure is achieved by entering into an operating agreement governing the relations among the members of the LLC.[12] Of course, if you are an entrepreneur without partners, then there is no benefit to having all of this structure documenting the relationship among the business owners. In addition, having bylaws or an operating agreement prepared costs money, so it, too, is not a benefit without a cost.

In sum, the two main benefits of incorporating your business are liability protection and documenting the relationship among owners. But those benefits come with some hidden costs that should also filter into the cost-benefit analysis of deciding whether to incorporate. In our next article, we’ll look at the more obvious costs of forming a new business entity.

[1] We’re setting aside the more complicated discussion of the possible tax benefits of forming a business entity at this point. For now, suffice it to say that it’s highly unlikely that average entrepreneurs will experience any tax savings from incorporating.

[2] Bonacasa Realty Co., LLC v. Salvatore, 109 A.D.3d 946, 947, 972 N.Y.S.2d 84, 85 (2d Dep’t 2013) (internal quotation marks omitted); see also We’re Assocs. Co. v. Cohen, Stracher & Bloom, P.C., 65 N.Y.2d 148, 151, 480 N.E.2d 357, 359 (1985) (“A principal attribute of, and in many cases the major reason for, the corporate form of business association is the elimination of personal shareholder liability.”)

[3] See, e.g., Lido Beach Towers v. Denis A. Miller Ins. Agency, 128 A.D.3d 1025, 1026, 11 N.Y.S.3d 192, 193 (2d Dep’t 2015) (corporate principals “may not be held liable on contracts of their corporations, provided they did not purport to bind themselves individually under such contracts”); Ruggiero v. FuturaGene, plc., 948 A.2d 1124, 1132 (Del. Ch. 2008) (same). In reality, the chances of an entrepreneur just starting out in business avoiding liability on a promissory note by having her newly formed business give the note are pretty slim, since most investors (banks certainly) will require the business owner to personally guarantee any loan to the business.

[4] The phrase “ramen profitable” was coined by Paul Graham and defined by him as meaning that “a startup makes just enough to pay the founders’ living expenses.” Paul Graham, Ramen Profitable, http://www.paulgraham.com/ramenprofitable.html (July 2009).

[5] See, e.g., Associated Vendors, Inc. v. Oakland Meat Co., 210 Cal. App.2d 825, 838-40, 26 Cal. Rptr. 806, 813-15 (1st Dist. 1962) (cataloguing many of the factors).

[6] In one of the studies we examined, it was determined that in cases where courts found that corporate management was “nonfunctioning”—that is, managers or officers were appointed, but they did not function normally, such as by holding meetings or keeping proper corporate records—the courts pierced the corporate veil in about four out of every five of those cases. John H. Matheson, Why Courts Pierce: An Empirical Study of Piercing the Corporate Veil, 7 Berkeley Bus. L.J. 1, 30, 34 (2010), http://scholarship.law.berkeley.edu/cgi/viewcontent.cgi?article=1068&context=bblj. Conversely, in cases where courts found that management was not nonfunctioning, they declined to pierce in about 87% of those cases and pierced in only 13% of the cases. Id.

[7] Id. at 31.

[8] See Burkhead v. Stewart Title Guar. Co., 649 F. App’x 567 (9th Cir. 2016) (“[U]ndercapitalization is determined at the time of incorporation and cannot be proved merely by showing that the corporation is now insolvent.” (internal quotation marks omitted)).

[9] See, e.g., Automotriz Del Golfo De California S. A. De C. V. v. Resnick, 47 Cal. 2d 792, 797, 306 P.2d 1, 4 (1957) (in bank) (“If a corporation is organized and carries on business without substantial capital in such a way that the corporation is likely to have no sufficient assets available to meet its debts, it is inequitable that shareholders should set up such a flimsy organization to escape personal liability. The attempt to do corporate business without providing any sufficient basis of financial responsibility to creditors is an abuse of the separate entity and will be ineffectual to exempt the shareholders from corporate debts. It is coming to be recognized as the policy of the law that shareholders should in good faith put at the risk of the business unincumbered capital reasonably adequate for its prospective liabilities. If the capital is illusory or trifling compared with the business to be done and the risks of loss, this is a ground for denying the separate entity privilege.” (internal quotation marks omitted)).

[10] See Aliya Medcare Fin., LLC v. Nickell, No. CV 14-07806 MMM (EX), 2015 WL 11072180, at *21 (C.D. Cal. Sept. 25, 2015) (“The ‘total absence of corporate assets’ is a factor which can require alter ego liability to be imposed.” (quoting Zoran Corp. v. Chen, 185 Cal. App. 4th 799, 811, 110 Cal. Rptr. 3d 597, 607 (6th Dist. 2010))).

[11] See, e.g., Cal. Corp. Code §§ 211 (adoption of bylaws), 301 (election of directors), 312 (appointment of officers).

[12] See, e.g., id. § 17701.10.