The “Form It and Forget It” Approach to Incorporating
Without more, even the most well drafted incorporation documents won’t do anything to protect an entrepreneur from liability. After all, documents are just paper. What protects an entrepreneur from liability comes after the formation of the corporation.
Sure, it goes without saying that the corporate documents have to be buttoned up, but liability protection can be lost through a process known as “piercing the corporate veil” if the corporation isn’t later treated like a “real” corporation. If that happens, the business owners become personally liable for business debts even though they incorporated!
Too often – business owners who incorporate take a “form it and forget it” approach; and the consequences of doing so can be a very big deal. In Krausz Puente LLC v. Westall, the owners of a business were personally liable for $4.5 million after the court found that the business owners paid personal expenses out of corporate funds; the corporation was undercapitalized; and financial records and corporate minutes were not properly maintained (even as to the most significant events in the history of the companies). In Stinky Love, Inc. v. Lacy , an entrepreneur was personally liable for $4.3 million where the business owner used the corporation’s assets to pay off his personal debts, including credit cards and automobile loans, and money was freely moved between personal bank accounts and those of the corporation.
It all boils down to what happens after incorporating. Entrepreneurs run into trouble where they exercise “complete domination and control over the corporation”. Figuring out whether the business owner had this sort of control over the corporation is based on the facts of the particular case, but over the years, courts in both California and New York have told us exactly what they are looking for:
- Commingling funds and other assets
- When the business owner treats corporate assets as his own (e.g., paying personal credit cards with corporate funds)
- The holding out by an individual that he is personally liable for the debts of the corporation;
- Failing to keep corporate minutes
For a complete list of the types of things that courts look at, see Piercing the Corporate Veil – A Rare and Drastic Result.
The lesson is clear: the corporation and its individual owners must be treated as separate for the protection to hold up.
To learn more, see Understanding How Courts Pierce The Corporate Veil.