subject: Shocking Results Of Not Incorporating Properly [print this page] Two great cases (one in California and one in New York) illustrate how entrepreneurs can get slammed when they take short cuts during the incorporation process. In each of these cases, the Court found that the failure to issue shares of stock was grounds for holding the shareholders personally liable for debts of the business. In the California case, for example, the court found that three individuals who had formed a California corporation to sell cars could be held personally liable for the balance due on cars purchased based on evidence that the corporation had never issued stock.
In recent years, jumping online to file Articles has been referred to all over the web as "incorporating". You can find hundreds of websites that sell "basic" incorporation packages that provide Articles, and you can frequently upgrade to a "premium" package that might include a fake-leather corporate book and seal where you can organize your Articles. The problem with all of this is that "incorporating" refers to a process that includes so much more than just the Articles, and if you don't take care of the entire process, the corporation will not hold up when you need it. A number of steps must be taken to properly form a corporate entity so as to preserve the principals' limited liability for doing business in the corporate form. See, What it means to properly form a corporation.
Issuing shares of stock is a particularly important step in the process in the eyes of most judges. Doing so is a legal requirement in all states. See, e.g., Cal. Corp. Code 416; N.Y. Bus. Corp. Law 508, and the failure to issue stock, although not conclusive evidence, is an indication that would-be incorporators were actually doing business as individuals.
In several cases, where the Articles are not in the proper form, courts have found the shareholders personally liable, because the corporation never "comes into being". For example, in one case, the business owner was held liable for more than $18,000 owed with regard to a lease that he had intended to make on behalf of a corporation. In another case, an individual was held personally responsible for more than $15,000 of obligations incurred for his nonexistent corporation.
Individuals faced with such unexpected personal liability may argue that they did their best to incorporate, and in fact, the law permits individuals faced with liability to argue that they "attempted" to incorporate. This is referred to as as a de facto corporation. But individual responsibility can be avoided only in rare situations. If the business is managed in the same way as it had been before the failed attempt to incorporate, with no effort made to comply with required corporate formalities, then there is no de facto corporation and personal liability will attach. In one case, for example, the court found no "de facto" corporation where "there were no meetings of the members or [directors], no election of officers, no bylaws adopted, no certificates of shares or membership issued, no seal adopted or used, [and] no records or minutes kept"). Most of these cases go badly for the shareholders, because it's rare when the proper steps are not taken at the time of formation, but later the business holds meetings, keeps minutes, etc.
So what is an entrepreneur to do if he or she is concerned about the corporation holding up? The good news is that it's fairly easy for an attorney to "clean up" a corporation that hasn't issued shares, prepared Bylaws, or taken all of the other steps required by law.
