Winter 2007 Edition

IS YOUR CORPORATE VEIL AT RISK?

By F. Stephen Glass

In a recent far-reaching decision, the North Carolina Court of Appeals held that the facts under examination supported a finding that the corporate defendant was the "alter ego" and mere instrumentality of the individual defendant/owner, permitting the plaintiff to "pierce the corporate veil" to hold the individual defendant/owner liable for the acts of the corporation.

The court, in East Mkt St. Square. Inc. v. Tycorp Pizza IV, Inc., 175 NC App 628 (2006), noted that the corporate defendant was so dominated by the individual defendant/owner that it had no separate mind, will or existence. Such a holding is not new law. The holding presents a very clear warning to all small corporations to take great care to keep the finances and operations entirely separate from those of the individual owner(s). It is particularly important for owners of small corporations to understand and follow the warnings set out in this case.

Our courts use the "instrumentality rule" to determine whether to disregard the corporate entity and hold the shareholder(s)/owner(s) liable for the acts of the corporation. This rule states that if the corporation is so operated that it is a mere instrumentality ("alter ego") of the sole or dominant shareholder and a shield for the shareholder(s)/owner(s), then the corporate entity will be disregarded and the corporation and shareholder(s)/owner(s) treated as the same person.

There are three elements necessary to pierce the corporate veil under the instrumentality rule:

1. Control, not merely majority or complete stock control, but complete domination, not only of finances, but of policy and business practice; and
2. Such control must have been used by the defendant owner to commit fraud or wrong; and
3. This complete dominion and control must be the proximate cause of the wrong done to the plaintiff.

Some of the facts found by the court Tycorp court to constitute dominion and control over the corporate entity by the shareholder(s) in the case are:

• The individual defendant was the sole director, sole shareholder, president and sole officer;
• The sole shareholder made all the decisions regarding the finances, policies and business practices of the corporation without any board of directors to oversee the shareholder's decisions.
• The sole shareholder was responsible for all contracts made by the defendant corporation and managed all of its negotiations. The plaintiff testified that all of his interactions regarding the lease negotiations were with the individual defendant and that he was not aware the of the corporate defendant.
• The defendant corporation had no assets except for an undocumented loan from another corporation owned by the individual defendant.
• The defendant corporation was formed simply to hold the lease at issue.
• The individual defendant commingled the funds of the defendant corporation with other entities.

The Tycorp court noted that it has previously considered the following factors in determining the level of control a shareholder exercised over a corporation:

• Inadequate capitalization ("thin corporation")
• Non-compliance with corporate formalities
• Complete domination and control of the corporation so that it has no independent identity.
• Excessive fragmentation of a single enterprise into separate corporations.

The Tycorp court pointed out that the mere fact that one person owns all of a corporation does not, standing alone, make the acts of the corporation the acts of the shareholder so as to impose liability on the shareholder. It is not the presence or absence of any particular factor that is determinative, the court said. Rather it is a combination of factors which suggest that the corporate entity attacked had no separate mind, will or existence on its own and was therefore the mere instrumentality or tool of the dominant shareholder-owner.

Some lessons corporate owners should learn from the Tycorp court's decision:

• Always comply with all corporate formalities (annual meetings, documentation of important corporate transactions, etc.).
• Never commingle corporate assets with your own.
• Utilize a board of directors and document all board decisions.
• Always do corporation business in the corporate name, not your individual name.
• Never use corporate assets (e.g., car) as your own.
• Keep corporate transactions completely separate from your own.

Small business owners should regularly utilize the services of their business lawyers.

Business Tax Law - S-Corp Treatment of Income or Losses

By F. Stephen Glass

An S-Corp is a pass-through entity (also known as a flow-through entity) since any income or loss related to the operation of the corporation flows through to the shareholders who report their share of the income or loss on their individual tax returns, If the S-Corp has a loss, that loss is generally available to offset the shareholders' other income. An S-Corp shareholder may not be able to claim a loss in a current year if the loss is prohibited under the "passive activity " rules. Nor may the S-Corp shareholder claim a loss if he or she lacks sufficient basis in the S-Corp stock. S-Corps that had been operating as C-Corps for a number of years prior to electing S status retain certain carryover tax attributes from the C-Corp days that can produce a tax liability at the corporate level before pass-through rules are triggered. This adds another level of complexity to the S-Corp's taxation. Therefore, it is very important to carefully evaluate the corporation's business plan BEFORE determining which corporate tax structure is right for the business. both short term and long term.

NEW ETHICS ACT MAY AFFECT YOUR BUSINESS

By M. Blen Gee, Jr.

If any aspect of your business involves influencing governmental policy decisions, the new North Carolina State Government Ethics Act may affect you. Here are a few of the issues your business should be aware of:

1. Gifts to public officials are prohibited, except for very narrow exceptions. Prohibited gifts can include tickets to ball games and meals.
2. The definition of lobbying has been expanded and includes attempting to influence policy decisions of administrative agencies, boards and educational institutions.
3. "Good will" lobbying is now regulated. If you host or sponsor an event where legislators or other public officials are invited, this is regulated and you should seek legal advice.

SMALL CLAIMS APPEAL TRAP

By M. Blen Gee, Jr.

WATCH OUT FOR THIS POTENTIAL TRAP IN SMALL CLAIMS COURT - Someone sues your company in Small Claims Court for $5,000. At your hearing, the judge awards the plaintiff $4,000 instead of $5,000. The plaintiff then appeals, seeking the full $5,000 he originally sued for. This is fine with you since you think the judge was clearly wrong and you should win in District Court. Two weeks later, however, you learned that the plaintiff has dismissed his appeal and your company is stuck with a $4,000 judgment against it!

If you want to protect your right to challenge a Small Claims judgment in District Court, you have to appeal as well. Otherwise, the plaintiff could simply dismiss his appeal and proceed to collect his judgment - plus court costs!

You can give notice of appeal orally at your hearing or in writing within 10 days after judgment is entered (get the Notice of Appeal form from the Clerk of Court). You have to pay the costs of court within 20 days after entry of the judgment, otherwise your appeal will be dismissed.

CONFIDENTIALITY OF EMPLOYEE INFORMATION - Mum's the Word in the Workplace

By F. Stephen Glass

Confidentiality can become an issue in many workplace situations. Some of the more obvious ones relate to protecting client or customer information. Businesses and professional organizations take great care to protect this type of confidential information.

Employers maintain a considerable amount of their employee's confidential information which should also be protected.

Employees are usually concerned that their performance appraisals and salary information remain confidential. Employees' personnel files should be kept securely and in such a way that privacy of that information is assured.

Employees are also concerned about inappropriate public discussion about their performance issues. Every good manager knows that an employee should never be corrected or reprimanded in front of others. The adage of "praise in public, criticize in private" is a good one. Employers should make sure that supervisors are clearly Instructed to keep employee's performance information confidential.

Confidentiality of an employee's medical information is especially important.

Companies should make sure that their employee handbooks conform to current law in the areas of confidentiality.

Confidentiality of employee information in the workplace has a practical significance. Breach of confidentiality can not only become a legal problem for the employer, it can also create a workplace atmosphere of distrust - one which is difficult and costly to repair.

EMPLOYMENT OF S-CORPORATION SHAREHOLDER-OWNERS

By F. Stephen Glass

S Corporations generally employ their shareholder-owners. Typically, corporate founders are employed in newly formed corporations.

A corporation is allowed a deduction for ordinary and necessary expenses paid out or incurred during a taxable year in carrying on a trade or business. Ordinary and necessary business expenses include a reasonable allowance for salaries or other compensation paid to shareholder employees for services actually rendered to the corporation.

S Corporation income allocated to a shareholder is not subject to self-employment tax. Thus, S Corporations and their shareholders often attempt to minimize wage or salary payments to themselves in order to minimize self employment tax.

While this is a good thing for S Corporation shareholder-owners, if the salaries set for the shareholder is unreasonably low (or nonexistent), or, if the shareholder receives a salary for services that were not actually rendered to the corporation, the IRS could turn too much of a good thing into a horrible nightmare. Beware!

 

About our authors:

M. Blen Gee, Jr. is an honors graduate of the University of North Carolina School of Law. His areas of concentration include business and corporate law, including sales of businesses; business litigation, including arbitration and mediation; franchise law; automobile dealer law; and insurance company insolvency. Mr. Gee has earned the highest peer-review rating for professional excellence and ethical standards by the national publication Martindale Hubbell.

 

F. Stephen Glass is the author of numerous publications on business and business entities as well as estate planning. He is a frequent presenter for the National Business Institute. His practice is concentrated in the areas of business and corporate law, business succession planning and estate planning. He serves on the Cary board of Capital Bank. Mr. Glass has earned the highest peer-review rating for professional excellence and ethical standards by the national publication Martindale Hubbell. He serves on the American Bar Association Business Law Committee on Corporate Governance.

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