Sole proprietorships and partnerships are not required to file their annual financial statements with the state. They dissolve if the owners die or cease doing business, and their owners have unlimited personal liability for business debts. Owners have full control over management decisions and cannot transfer their interests directly. States impose no filing fees and few operational restrictions, and neither structure functions as a taxable entity. Income is passed to owners, who are responsible for tax liabilities.
In contrast, corporations must pay a state filing fee, are perpetual unless formally dissolved and are managed by either directors or members. In either an S corporation or a limited liability corporation (LLC), income is passed through to shareholders, who pay taxes personally. A C corporation retains earned income, pays the taxes and may distribute after-tax dollars to shareholders as dividends. Stock ownership is easily transferred (depending on IRS regulations and internal restrictions) in a C corporation, and the “corporate veil” protects shareholder assets from corporate debts or liabilities.
An S corporation is created by filing IRS Form 2553, and ownership is limited to 100 individual shareholders who are U.S. residents. Shareholders cannot be corporations, trusts or partnerships. Limited liability corporations (LLCs) and C corporations have no such restrictions. All corporations must file articles of incorporation with the state in which they are incorporated, and meet specific, rigid filing dates.
The state also requires corporations (except for LLCs) to hold annual meetings of shareholders and directors and to keep minutes of those meetings in the permanent corporate records. While S and C corporations exist in perpetuity, the LLC has a defined life span and must list a dissolution date in its articles of incorporation.
Events such as the death or withdrawal of a member can also trigger dissolution. Members of LLCs must approve stock transfers, while S corporation shareholders may freely transfer their ownership interest. Management decisions in C and S corporations are made by directors, who are elected by the shareholders. LLCs may be run by either by managers or members, in which case they would operate more like a partnership.
Maintaining the protection of your corporate veil requires you to comply with state requirements: file articles of incorporation and annual (or biennial) financial statements and pay mandatory fees to remain in good standing. Bad standing can lead to “administrative dissolution” by the state, meaning the corporation no longer exists and the owners lose liability protection.
States also require an organizational meeting of directors to adopt bylaws, elect officers and issue stock to shareholders. The bylaws are the second-most important corporate document—after articles of incorporation—since they govern how the company will be operated. At all times, the officers and directors must visibly be acting on behalf of, and in the best interest of, the corporation and its shareholders, especially when officers or directors enter into contracts.
In closely held private corporations, items of business are often determined unanimously by shareholders in lieu of holding the annual meeting, and the related documents must be kept with corporate records.
You must also maintain a stock ledger, recording all shares issued and the contributed amount represented by each share. Corporate records must also contain any contracts entered into by the corporation.
You are required to keep financial records, including payments received, disbursements, invoices issued (accounts receivable) and invoices received (accounts payable), for a minimum of seven years. Document any loans taken, along with repayment terms, especially those related to shareholders. Corporate records must also include balance sheets and profit and loss statements.
Corporate owners have a duty to maintain the separation of the corporate entity from their own personal interests. If you are not following legal or operational rules and your company is sued, the plaintiff will try to name you personally as a shareholder, citing your failure to maintain a distinct separation between yourself and the corporation. One item alone may not be enough to allow the piercing of your corporate veil, but multiple items often combine to cause that result.
Three common reasons for courts to rule that the corporate veil has been pierced include commingling of owner and business assets; shareholder engagement in illegal, fraudulent and/or negligent acts (which may also attach criminal penalties); and inadequate business capitalization.
Inadequate capitalization poses the greatest risk for many contractors, especially in times of asset restructuring, cash flow reduction or failure to adequately implement and enforce collection policies. It is good business to target the best clients, negotiate the fairest contracts and insist on prompt payment flow, and it also helps to protect your corporate veil. EC
NORBERG-JOHNSON is a former subcontractor and past president of two national construction associations. She may be reached at email@example.com.