Business Lawyers Blog

Once you have started your own business, one of the first decisions you must make is choosing the form in which you want to conduct your business – whether as a sole proprietorship (or partnership, in case of more than one founder) or by organizing your business in an entity form. Your choice will lay the foundations for your business and guide tax efficiencies, liability exposure, administrative ease, attractiveness to investors, and therefore, your ability to scale. Also, choosing a form that best fits your needs helps avert disputes and prevent misunderstanding among the stakeholders by defining their ownership, roles, and duties in the business.

Whether your business should be organized as a corporation, partnership, limited liability company (“LLC”) or a sole proprietorship, depends on various factors including your goals for the business, whether you intend to raise outside capital, whether your business will be a lifestyle business, your desired tax treatment for the business, whether you intend to offer equity to employees and service providers, and so forth. However, in this blog we limit our discussion to adding our two cents to the ever-going debate of whether a new business should organize as a C-corporation (“C-Corp”) or an LLC. Our conclusion, to no ones’ surprise we hope, is there is no one-size-fits-all answer.

Arguably, one of the biggest drawbacks of a C-Corp is the potential for double taxation. A C-Corp is a separate taxpayer independent of its stockholders. The income earned by the C-Corp is first taxed at the entity level and then again in the hands of its stockholders when the net income is distributed to them as dividends[1]. For the same reason, distributing cash to the owners on an ongoing basis is difficult to accomplish with a C-Corp (though by no means impossible). Also, to avail the protection from personal liability that C-Corp affords its owners (and to avoid the piercing of the so called “corporate veil”), it is important that a corporation complies with all corporate formalities stringently. LLCs (which also shields its owners from personal liability) offer much more flexibility in matters of corporate governance. Also, statutorily mandated fiduciary duties of the board of directors of a corporation cannot be eliminated by the corporation’s owners via a private agreement, whereas the members of an LLC have much flexibility to reduce (or altogether eliminate in some states) a manger’s (or managing member’s) fiduciary duties to the LLC and its non-managing members through the LLC’s operating agreement.

We often see business owners ignore corporate formalities after incorporating their businesses. They labor under the misconception that forming a corporation[i], provides them with a full-proof shield from personal liability, despite how they conduct corporate affairs post incorporation. Many are not aware of the doctrines of “piecing the corporate veil” or “alter ego”. In this blogpost, we discuss briefly why corporate formalities are important to follow— owners of incorporated businesses must follow corporate formalities to ensure protection from personal liability.

Why corporate formalities are important to follow? The short answer is because following corporate formalities ensures the separateness of identity between the corporation and its owners is maintained. This is essential to ensure personal liability protection for the owners. Under the corporate statutes of all jurisdictions, after a corporation is formed it is treated as a separate “person” distinct from the owners holding interests in it.  This separateness of legal identity shields the corporation’s shareholders, officers, and directors, from personal liability from the debts and obligations of the business. However, the important caveat is this protection is available only if steps are continuously taken through observing of corporate formalities to maintain the separateness of the corporate entity from its owners.  If owners do not observe corporate formalities and run their business like a sole proprietorship (or partnership in case of more than one owner) and if a creditor or an obligee of the business sues to hold the owners personally liable, a court will likely disregard the corporate shield to hold the owners personally liable. This is the so called “piercing the corporate veil”—a doctrine under which the courts can disregard the corporate entity and hold its owners personally liable for the corporation’s debts and obligations. In California this is done under the “Alter Ego” doctrine. Under this, a court will hold business owners of a corporation personally liable if it finds (a) a unity of interest and ownership between the corporation and its owners (that is these owners have treated the corporation as their “alter ego” rather than as a separate entity); and  (b)  it will be an inequitable result if these acts are treated as those of the corporation alone and failing to hold shareholders accountable would sanction a fraud or promote injustice.  Burden of establishing alter ego liability is on the plaintiff creditor.  Therefore, mere incorporation of a business will not shield its owners from personal liability if they have failed to follow corporate formalities post-incorporation.

So, what are considered corporate formalities? Some of the many examples of corporate formalities that must be observed to ensure owners are shielded from personal liability are: