201412.10
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Adequate Capitalization – Keeping the Corporate Veil Intact

Do your corporate numbers add up?

One of the most important aspects of maintaining the protections of corporate status is making sure that the corporation is “adequately capitalized” both upon its formation and during its existence. Adequate capitalization is a technical legal issue that can’t be fully covered in a blog post, but the main thing business owners who choose to incorporate need to know is that if the corporation is deemed to be “under-capitalized” then the corporate “veil” (i.e., the wall that protects the personal assets of the owners from the corporate obligations) may be “pierced” resulting in individual liability for the owners.

What Is Adequate Capitalization?

California law requires that a corporation must have equity (i.e., funds and other property paid to the corporation for the purchase of its stock) in an amount that is “adequate” to give it “independent substance” in relation to the obligations likely to be taken on in connection with the corporation’s business. If the amount of equity is “trifling compared with the business to be done and the risk of loss,” then the law will conclude that the corporation had no realistic, reasonable chance of ever being able to pay its ongoing obligations. This means that the people operating the corporation (which will be, depending on the circumstances, the founders, shareholders, officers and/or directors) can be held personally liable for the corporation’s debts, obligations and liabilities.

How Is Adequate Capitalization Achieved?

A California corporation can be capitalized through a combination of:

  1. “Equity” may include money and other property paid for the purchase of stock by a corporation’s founders and others; and
  2. “Debt” may include money loaned to the corporation by its founders, other private parties, and institutional lenders.

There are important differences between equity and debt. The main difference is that equity constitutes the ongoing capital of the corporation and, once infused into the corporation, it can only be withdrawn in some taxable way (e.g., through the payment of salary, bonus, or stock dividend). Debt, on the other hand, is viewed in the nature of temporary capital since it must, at some point, be paid back. When it is paid back, it is not taxable since the funds have only been lent to the corporation and the borrower is merely being paid back its own funds.

Although there is no bright line test for what constitutes “adequate” capital, the founders and initial shareholders should, at a minimum, capitalize the corporation with sufficient equity (in the form of cash and other assets paid in exchange for the corporation’s stock) necessary to enable the business to reach its projected break-even point, based on their own reasonable and good faith estimates. If they do so, the founders and initial shareholders should be able to avoid being held personally liable for the corporation’s debts, obligations and liabilities based upon inadequate capitalization, even if their projections turn out to be wrong and the business fails, as so many new and other businesses do.

The Bottom Line

It is important for a corporation to remain in contact with a business attorney and an accountant to keep them apprised of capitalization levels. In doing this, the corporation will ensure that the important players on their team can advise on whether it is operating with sufficient capitalization to maintain corporate protections.

If you are thinking of incorporating your business or if you have already done so, contact Jeffrey Miller to find out how he can help you maintain corporate protections. (650) 321-0410 or [email protected].