The Importance of Observing Corporate Formalities
By: R. James Young
Wells Marble & Hurst, PLLC
Jackson, Mississippi
Shareholders of a corporation may face dangerous consequences if the corporation fails to observe corporate formalities. Where the corporation has failed to hold meetings, keep minutes, maintain adequate financial records, or submit its required filings with the Secretary of State, the corporate entity may be ignored by tort victims, creditors, or tax authorities, and the shareholders may be held individually liable.
Most grounds for disregarding the corporate entity ("piercing the corporate veil") can be categorized more broadly as a failure to follow formalities. Some problems that may lead to veil piercing, such as commingling of corporate and personal funds, can be fixed by following formalities that are often easily accomplished. Maintaining separate bank accounts for the sole-shareholder and the corporation is a rather simple formality that will help prevent commingling. With the appropriate documentation and formalities, withdrawals of corporate funds by a shareholder can often be treated as salary, thus avoiding the problem of using a corporation's funds as if they were the shareholder's own personal property. However, where the shareholder fails to follow formalities and conducts private and corporate business interchangeably, the court and tax authorities may treat the corporation and the shareholder interchangeably by ignoring the existence of the corporation and holding shareholders individually liable.
Tort and Contractual Liability
Although shareholders of a corporation generally have limited liability with respect to corporate obligations and liabilities, the Court may disregard the corporate entity and hold shareholders individually liable in certain circumstances. Factors that may increase the likelihood that a court will pierce the corporate veil include the failure of the corporation to observe corporate formalities such as holding regular meetings of shareholders and directors and the failure to keep minutes of those meetings.
In Gray v. Edgewater Landing, Inc., 541 So. 2d 1044 (Miss. 1989), a landlord filed a counterclaim against a tenant corporation for breach of lease and sought to hold shareholders individually liable. The Court held that the shareholders were not individually liable because the landlord had failed to meet the requirements for disregarding the corporate entity. The Court found, at least in the contractual liability context, that:
To cause a court to disregard the corporate entity and justify shareholder liability, the complaining party must demonstrate: (a) some frustration of contractual expectations regarding the party to whom he looked for performance; (b) the flagrant disregard of corporate formalities by the defendant corporation and its principals; and (c) a demonstration of fraud or other equivalent misfeasance on the part of the corporate shareholder.
The Court found that the landlord failed to prove any of the three requisites, specifically noting that the landlord "offered no proof that corporate formalities were not followed" and that "the evidence suggests the contrary, that formalities were at all times adhered to."
In Thames & v. Eicher, 373 So. 2d 1033 (Miss. 1979), the Court disregarded the corporate structure and found Rogers, owner of all the stock of Thames & Co., individually liable for sale of a defective house. The corporation held no regular meetings and kept no minutes. The Court found that Thames & Co. was merely the alter ego of Rogers, who was unable to even recall who the directors of the corporation were.
In Kramer v. Keys, 643 F.2d 382 (5th Cir. 1981), the Court upheld the piercing of the veil of the corporate employer of a driver in a wrongful death action arising out of an automobile accident. The Court found the principal, Ralph Walker, individually liable for the plaintiff’s injuries because the corporation was simply an "empty shell." The Court cited the following as evidence that justified disregarding the corporate entity:
(i) under-capitalization, (ii) no regular shareholder or director’s meetings, (iii) mixing of his personal assets with that of the corporation to the extent of taking depreciation for both on the corporate income tax returns, (iv) executing truck leases in his individual name, (v) filing of accident reports in his individual name, (vi) the use of rubber stamp "Ralph Walker" on corporate documents, and (vii) being the sole stockholder and president of Ralph Walker, Inc.
In Carolina Transformer Co. v. Anderson, 341 So. 2d 1327 (Miss. 1977), the owner of a corporation continued to operate the business in the corporate name after the corporation was suspended from doing business by the Secretary of State for failure to file its annual report. The Court found that the owner was individually liable as a sole proprietor for debts incurred after the suspension of the corporation by the Secretary of State.
Tax Consequences
The IRS and the Mississippi State Tax Commission normally treat a corporation as an independent taxpaying entity where the formalities of corporate operation are not observed, and the courts may deny the form of a particular transaction, often with disastrous tax consequences. Properly drawn corporate minutes and other documents will formalize a transaction and give the corporate taxpayer a greater opportunity to avoid any disregard of the corporate entity by the Court.
In Lowry v. Comm’r of Internal Revenue, 262 F.2d 809 (2d Cir. 1959), Lowry contended that the reason he did not report income he received from the corporation of which he was the sole stockholder was that those amounts were either reimbursements for loans he made to the corporation or corporate expenses paid out of his funds. The Court did not accept Lowry's justification, because the corporation failed to maintain adequate records of any loans payable to Lowry and there was nothing to show that the “loans” were not capital contributions by Lowry. The Court held that the Commissioner of Internal Revenue was justified in determining deficiencies in income taxes based on the money Lowry received from the corporation.
In Bramlette Building Corp. v. Comm’r of Internal Revenue, 424 F.2d 751 (5th Cir. 1970), the corporation had claimed a deduction for salary paid to its president, who owned 99.86% of the corporation's stock. The Court denied the salary deduction, finding that the payments to the president were actually dividends. In making that determination, the Court found that the lack of any recorded corporate authorization for the payments as salaries was a significant consideration.
In Jacques v. Comm’r of Internal Revenue, 935 F.2d 104 (6th Cir. 1991), Jacques claimed that the amounts he withdrew from his wholly owned professional corporation were loans, not taxable distributions. The Court found that the "loans" were actually taxable distributions because Jacques’ failure to follow any of the corporate formalities which would usually accompany such a loan meant that he failed to prove any "objective manifestations of contemporaneous intent to repay." The Court noted that to hold otherwise would allow Jacques to escape the double taxation of the corporate form by allowing him to postpone repayment indefinitely.
Formalities Required by Statute
The following are examples of the formalities that Mississippi corporations are required by statute to follow:
"A corporation shall hold annually at a time stated in or fixed in accordance with the bylaws a meeting of shareholders." Miss. Code Ann. § 79-4-7.01(a).
"The bylaws or the board of directors shall delegate to one (1) of the officers responsibility for preparing minutes of the directors’ and shareholders’ meeting and for maintaining and authenticating records of the corporation." Miss. Code Ann. § 79-4-8.40(c).
"A corporation shall keep as permanent records minutes of all meetings of its shareholders and board of directors, a record of all actions taken by the shareholders or board of directors without a meeting, and a record of all actions taken by a committee of the board of directors in place of the board of directors on behalf of the corporation." Miss. Code Ann. § 79-4-16.01(a).
"A corporation shall maintain appropriate accounting records." Miss. Code Ann. § 79-4-16.01(b).
"A corporation or its agent shall maintain a record of its shareholders, in a form that permits preparation of the names and addresses of all shareholders, in alphabetical order by class of shares showing the number and class of shares held by each." Miss. Code Ann. § 79-4-16.01(c).
"A corporation shall furnish its shareholders annual financial statements..." Miss. Code Ann. § 79-4-16.20(a).
"Each domestic corporation, and each foreign corporation authorized to transact business in this state, shall deliver within sixty (60) days of each anniversary date of its incorporation with respect to a domestic corporation or its authorization to transact business in this state with respect to a foreign corporation, or such other date as may be established by the Secretary of State, to the Secretary of State for filing an annual report...." Miss. Code Ann. § 79-4-16.22(a). If the corporation does not deliver its annual report to the Secretary of State within sixty (60) days after it is due, the Secretary of state may commence a proceeding to administratively dissolve the corporation. Miss. Code Ann. § 79-4-14.20(2).
CONCLUSION:
Diligent observation of corporate formalities can make the difference between preservation of the corporate entity or potentially catastrophic liability of individual shareholders. When the corporation has failed to hold meetings, keep minutes, maintain adequate financial records or submit its required filings with the Secretary of State, the corporate entity may be ignored by tort victims, creditors or tax authorities, and the shareholders may be held individually liable. The value of any time or expense saved through failure to follow corporate formalities may seem trivial when compared to the shareholders’ exposure to liability resulting from a piercing of the corporate veil.
Wells Marble & Hurst, PLLC
P. O. Box 131
Jackson, MS 39205-0131
(601) 605-6900
