Observing Corporate Formalities
Most business owners who have a corporation or LLC (hereinafter referred to as a "company") understand the basic legal concept of why they run their business out of a company. Setting aside the issue of tax benefits that may be gained, the primary legal reason you conduct your business through a company is so that if there is ever any liability incurred to the business, that liability attaches to the company, not to the individual person who owns the company. However, understanding this concept is not enough, and setting up a company is not enough. To effectively protect against personal liability, the business owner must properly use the company.
Let's suppose that John Smith is the sole owner of Smith Retail, Inc., which sells widgets out of a small gift store in a shopping mall. One day an angry client files a lawsuit against John Smith, individually, claiming that the widgets he purchased were defective. Mr. Smith's first obvious questions will be "why is the plaintiff suing me?" and "aren't they only allowed to sue my company?" Mr. Smith's attorney will also ask the judge the same questions, hoping that the case against Mr. Smith is dropped, and that the plaintiff only be allowed to sue Smith Retail, Inc.
Before the judge will make that determination, however, he will ask Mr. Smith to prove that his widget business is actually being operated through Smith Retail, Inc., and not through Mr. Smith personally. That analysis will include the following questions:
- Is there, in fact, a corporation called Smith Retail, Inc.? Is it in good standing with the state's department of corporations? If Mr. Smith has let his corporate entity lapse, and it is not in good standing, then this improves the argument of the plaintiff that the business is not legitimately being run through a corporation.
- The business operates out of a leased space in the shopping mall....is that a lease between the Landlord and John Smith? Or between the Landlord and Smith Retail, Inc.?
- The business must be operating under a business license issued by the local city/county.....is that business license issued to "John Smith d/b/a Smith Retail?" or is it issued to "Smith Retail, Inc.?"
- Is the business bank account in the name of John Smith? Or in the name of Smith Retail, Inc.? Are the employees being paid from a bank account of the company? or from funds of John Smith personally?
- To whom is the Federal Tax ID Number (also known as an EIN) of the business issued? To John Smith? or to Smith Retail, Inc.
- In whose name are all of the utility accounts (i.e., water, electrical, etc.) of the store? In the name of John Smith? Or Smith Retail, Inc.?
If the answers to these questions reveal that most things are set up in Mr. Smith's personal name, and not many things are set up in the corporation's name, then there is a decent argument that the business is really being operated as a sole proprietorship on the account of Mr. Smith, personally. The fact that he formed a company makes no difference if he's not actually using it to operate his business.
Attorneys refer to these details as "corporate formalities," and they seem like petty details if you ponder any particular one. If any one of these things is in the personal/individual name instead of the company name, then it's not the end of the world, and the judge would hopefully let Mr. Smith escape personal liability. However, when you look at the entire list of corporate formalities as a whole, they give a decent picture of how the business is actually being run, and if most of these certificates, accounts, licenses, and contracts are in Mr. Smith's name and not in his company's name, he may very well end up getting personally sued, notwithstanding the fact that he has a corporation.
It may seem like an obvious and silly thing to point out that you're supposed to set up everything in the company name when using a company to operate a business, but business owners unintentionally screw this up all the time. One common mistake is setting up all of the accounts, licenses, and contracts for the business before the company is even formed. You can't open a bank account, or enter into a lease, in the name of a company before the company exists. If you hire the attorney to set up your company at the very end of the start-up process, after you've set up everything else, then you may have to go back and re-do everything in the name of the company, since you originally set it all up in your personal name.
When a plaintiff is allowed to sue the owner of a corporation, instead of (or in addition to) suing the corporation itself, attorneys call that "piercing the corporate veil." If the business owner properly sets everything up in the company name, then piercing the corporate veil is very difficult, if not impossible.