If you want to incorporate your business, state laws establish various requirements that you must fulfill to properly obtain the protective benefits offered by doing business as an entity. You can choose to incorporate in a state other than where you will operate the business, but you must comply with the laws of the state where you are filing. Sometimes, business owners are unaware of all the rules or make technical errors and they fail to properly incorporate. That can have significant repercussions resulting in personal liability for shareholders. There are instances when courts will forgive mistakes, but best practice is always to avoid making them.
A de jure corporation is one that was formed in compliance with a state’s laws. It is a legally recognized, properly formed entity and is distinct from its shareholders. Among the benefits of being a de jure corporation is that the shareholders are afforded personal liability protection. Generally, shareholders are not personally liable for the debts of the business with a few exceptions. This is because a corporation has a separate legal existence from its shareholders.
Generally, a de facto corporation is a business that failed to properly incorporate but operates as if it was a corporation. The situation arises when the company did not comply with the technical requirements of the law for good-faith reasons or errors. The owners are not aware of their mistakes and continue to conduct business as a corporation. Although a corporation was not duly formed, in limited cases, the shareholders and representatives can still avoid personally liability for the company’s debts. The purpose of this doctrine is to provide liability protection where there was not any.
Typically, shareholders or company representatives invoke the doctrine of de facto corporation when they are sued personally by a third party. They want the same protections they would receive as if the business was a lawful corporation. To succeed, they must establish the following requirements:
If a company meets the requirements of a de facto corporation, its shareholders and representatives can still receive limited liability protection from third parties similar to the protections afforded to the shareholders of a de jure corporation.
Further, if a business is neither a de jure nor de facto corporation, shareholders and representatives of the company may still receive some liability protection with respect to a particular transaction or contract dealing if the opposing party acted as if it were doing business with a corporation. This is known as corporation by estoppel. It is an equitable remedy used to shield someone who acts “as if” he or she was acting on behalf of a corporation or with a corporation. Essentially, a court decides that it is not fair under the circumstances for the shareholder/representative to be held personally liable in the transaction because the opposing party believed that it was doing business with a corporation and thus should have had an expectation that a liability shield existed. As a result, the court determines that the plaintiff should be estopped from now denying the existence of a valid corporation.
Complying with state laws regarding incorporation is vital to ensuring that shareholders and representatives obtain the intended protections of corporate law. While shareholders and company representatives may get a reprieve from personal liability under the doctrines of de facto corporation and corporation by estoppel, they still must litigate and prove their case. In both instances, it is essential to consult legal counsel to avoid costly results, including allowing third parties to make claims of the personal assets of shareholders and representatives. Contact an experienced attorney for advice on the best ways to incorporate your business so that your shareholders and officers can avoid unintended consequences cause by defective incorporation.