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Corporations Defined

 

The following information deals primarily with the small, privately owned corporation. It assumes that all of the corporate stock is owned by one person or a few people, and that all shareholders are actively involved in the management of the business -- with the possible exception of friends and relatives who have provided seed money in exchange for stock. Because there are many complexities involved in selling stock to the public, this article does not discuss public corporations.

The most important feature of a corporation is that, legally, it's a separate entity from the individuals who own or operate it. You may own all the stock of your corporation, and you may be its only employee, but -- if you follow sensible organizational and operating procedures -- you and your corporation are separate legal entities.

All states but Arizona have adopted legislation that permits a corporation to be formed by a single incorporator. All states permit a corporate board that has a single director, although the ability to set up a one-person board may depend on the number of shareholders. In addition, many states have streamlined the procedures for operating a small corporation to permit decisions to be made quickly and without needless formalities. For example, in most states, shareholders and directors can take action by unanimous written consent rather than by holding formal meetings, and directors' meetings can be held by telephone.

Limited Personal Liability
One of the main advantages of incorporating is that, in most circumstances, it limits your personal liability. If a court judgment is entered against the corporation, you stand to lose only the money that you've invested. Generally, as long as you've acted in your corporate capacity (as an employee, officer, or director) and without the intent to defraud creditors, your home and personal bank accounts and other valuable property can't be touched by a creditor who has won a lawsuit against the corporation.

Example
Andrea is the sole shareholder, director, and officer of Market Basket Corp., which runs a food store. Ronald, a Market Basket employee, drops a case of canned food on a customer's foot. The customer sues and wins a judgment against the business. Only corporate assets are available to pay the damages. Andrea is not personally liable.

Caution: Liability for your own acts. If Andrea herself had dropped the case of cans, the fact that she is a shareholder, officer, and director of the corporation wouldn't protect her from personal liability. She would still be personally liable for the wrongs (called torts, in legal lingo) that she personally commits.

So much for theory. In practice, incorporating may not actually give you broad legal protection. In the real world, banks and some major corporate creditors often require the personal guarantee of individuals within the corporation. So the limited liability gained from incorporating isn't always as valuable a legal shield as it first seems.

Example
Market Basket Corp. borrows $75,000 from a bank. Andrea signs the promissory note as president of the corporation, but the bank also requires her to guarantee the note personally. The corporation runs into financial difficulties and can't repay the debt. The bank sues and wins a judgment against the business for the unpaid principal plus interest. In collecting on the judgment, the bank can go after Andrea's assets as well as the corporation's property. Incorporation offers no advantage over a sole proprietorship.

Liability insurance can protect against many of the risks of doing business. But if you operate a high-risk business -- child care center, chemical supply house, asbestos removal service, or college town bar -- and you can't get (or can't afford) liability insurance for some risks that you're concerned about, incorporation may be the wisest choice.

Example
Loren is afraid that a clerk at his After Hours beverage store might inadvertently sell liquor to an underaged customer or one who has had too much to drink. If that customer got drunk and hurt someone in a car accident, there might be a lawsuit against the business.

Loren contacts his insurance agent to arrange for coverage, but learns that his liquor store can afford only $50,000 worth of liability insurance. Loren buys the $50,000 worth of insurance, but also forms a corporation -- After Hours Inc. -- to run the business. Now if an injured person wins a large verdict, at least Loren won't be personally liable for the portion not covered by his insurance.

The lesson of these examples is clear: Before you decide to incorporate your business primarily to limit your personal liability, analyze what your exposure will be if you simply do business as a sole proprietor (or partner).

The limited liability feature of corporations can be valuable, protecting you from personal liability for:

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