The main purpose of incorporating is to protect your personal assets from potential business liabilities. However, if certain formalities are not followed you will quickly learn the meaning of the legal term “piercing the corporate veil.” When this happens, your home, car, personal investments and bank account are all at risk of being seized by a creditor if you get in legal trouble and lose the case.
In order to be sure that your new corporation will actually protect you and your personal assets from business liabilities, you need to take steps that will show you take your business seriously. Among these steps are:
- Follow the corporate formalities at the time of incorporation, including holding an organizational meeting to determine who the officers and directors are, issue shares of stock in exchange for cash or services that will constitute your initial capital
- Hold annual meetings of the shareholders and directors
- Make sure any substantial decisions are covered by board resolutions
- Keep accurate bookkeeping records
- Make sure that you never take money out of your corporation that is not covered by a pre-established process: board approved salary, board approved dividends or board approved bonuses
- Never mix corporate funds and personal funds
Every size of business faces this same risk of “piercing the corporate veil,” but for small, startup businesses with one or two owners, there is a special risk: the fact that the owner(s) and manager(s) are the same people creates a suspicion in the court that the company is just an “alter ego” of the owners, and that the corporation is really just one and the same as the owners. The temptation to take shortcuts from the formal procedures mandated by law is overwhelming, and there is rarely pressure from outside the company to worry about it – until it matters. The above steps will help undo this suspicion by showing that the corporation is being taken seriously, and that had the owners and managers been different people that all the same decisions would have or could have been made. The extensive use of “arms-length transactions” and the avoidance of “commingled funds” helps prove that your corporation is for real and not just your personal piggy bank.
If you fail to follow these requirements, you can bet that when you are confronted by a well-funded opponent (including the IRS and the tax departments of the states), your corporate protection will disappear faster than you can say “bankruptcy.”
As an added bonus, corporations that follow set procedures (“good corporate governance” is the formal term) do better on average than those that are less formal, almost certainly because the added structure helps the owners to think more strategically about their business. When getting involved in a startup, keep it in mind that right at the time of incorporation it’s important to open up the corporate kit and take care of those inconvenient formalities and establish the proper procedures from the beginning.