Do you REALLY have a Corporation?

The other day, I had a depressingly familiar conversation with one of my small business clients. She had come to my office to have me draw up paperwork to add her new business partner as a shareholder of her closely held corporation. She informed me that the company used to be an LLC, but that she had changed it to a Sub-chapter S corporation a few years ago on the advice of her accountant. When I looked her company up on the State Corporation Commission database, it was, predictably, still listed as a limited liability company. When I asked what forms she had submitted to convert her entity to a corporation, she replied that she didn't know - her accountant had taken care of that.

Except that he hadn't. By taking the bad legal advice of a non-lawyer, she had been paying her taxes incorrectly for several years. Now, we have a mess to unravel.

We live in a world in which it certainly seems like everything can be handled over the internet by clicking a few buttons or downloading a simple form. Dozens of websites purport to offer quick, cheap legal services, such as incorporation, wills, and contracts and this has given the impression that anyone can perform these services for themselves... or for others.

It doesn't help that most states have simplified their corporate registrations such that you can now register your corporation online and get a certificate of incorporation or organization in minutes. This is a huge convenience, but it is not the end of the story. Virginia, like most other states, has a whole section of the code dedicated to incorporated entities and those statutes lay out a number of duties that a company must comply with in order to be considered a valid LLC or corporation.

Once formed, the law governs how a company or corporation must operate. For an LLC, that includes maintaining capital accounts for members and setting up procedures for member votes, admitting and dissociating members and winding up the company if it goes out of business. For an incorporated entity, you can add a bunch of additional rules, including requirements for annual shareholder and director meetings, rules relating to voting by proxy, notice requirements and restrictions on the types of stock that can be issued, just to name a few.

What happens if you just ignore all of that? Bad stuff. Under the law, if a company or corporation does not follow the formalities, then the corporate form may be disregarded and the owners are personally liable for all of its acts and debts. In other words, people and creditors of the company can sue the owners personally. It's worth adding that it is a misdemeanor crime to intentionally operate a fake company.

This is because the corporate entity is a powerful tool under the law. It allows people to conduct business as if the company or corporation were a separate legal entity. That legal entity only exists if the owners follow all of the rules and all of the formalities that make it exist. If all a person did was fill out a form on the State Corporation Commission website, then the actual company would be nothing more than a sham.

Many people who go into business for themselves or with a partner or two also download and sign "generic" company documents, such as LLC operating agreements, that they neither read nor understand. Under the law, there's no such thing as "standard language." Every word in a 10 page operating agreement has meaning and binding effect. This can have serious consequences.

Consider the following example: Bob and Suzy decide to open a restaurant. Bob is a world-class chef but has no cash and lacks business skills. Suzy is a shrewd business manager who has $100,000.00 to invest in the venture to get it off the ground. They decide to be 50/50 partners and agree that Bob's know-how is of equal value to Suzy's cash investment. So, they form an LLC and download a generic operating agreement from a website. In the agreement, they list the initial capital contribution as $100,000.00 and state that each owns a 50% membership interest. Sadly, two weeks before the restaurant is set to open, Bob gets a lucrative offer from a top restaurant in Manhattan and decides to bail on the business. Suzy is now stuck - even though she put up all of the cash and will be stuck holding the bag for all of the debts, Bob has demanded to withdraw his half of the company's capital, which is still listed as $50,000 on the company's records.

In that example, Suzy may well find herself stroking a check to Bob for his share. First, the amount of capital was noted wrong on the initial agreement and, if they never adjusted the capital accounts as the capital was used by the company to build up the business, Bob may have a very good claim for his half of the capital, even though he never invested a penny of his own money.

There are plenty of examples of business owners ending up with terms and conditions in their agreements that they never would have wanted, had they gotten proper advice. I once had a client who had simply copied an operating agreement from one he had used many years before. When he and his partner came to an unsolvable disagreement, they were shocked to discover for the first time that the operating agreement required that all lawsuits between the members be filed in California.

Yes, it will cost you a little bit more to hire a lawyer to prepare your company documents than just downloading a form off of a dubious website. But it will cost you a WHOLE LOT more to hire a lawyer later on to fix all of the problems that you will create by doing your own home-lawyering. If they can be fixed at all.