Proper Maintenance of Your Arizona Corporation

By: Gary Michael Smith, Esq.

To most contractors, the twin biggest benefits to incorporating are tax advantage and limitation on personal liability. However, failure to adhere faithfully to corporate formality could cause the catastrophic loss of both. In my law practice I see many incorporated contractors who have fundamental misunderstandings about maintaining their corporate formality. These contractors think that their legal obligations regarding their corporations stop after formation or at tax time. However, nothing could be further from the truth.

Under state statutory authority, a corporation is a fictional legal entity, separate and distinct from its owners, the shareholders. Arizona statutes grant corporations certain rights and powers including the power to contract, to own property, to sue and to be sued. Arizona law also insulates the shareholders from personal liability on corporate debts. However, what protections Arizona law grants may also be taken away.

In simple terms, shareholders can become personally liable for corporate debts whenever the corporation and / or its shareholders fail to adhere to corporate formality. This involuntary imposition of personal liability contrasts sharply with situations where shareholders voluntarily become personally responsible for corporate debts, such as through personally guaranteeing corporate obligations. The voluntary assumption of responsibility is not the concern of this article. Rather, it is the involuntarily imposition of corporate liability on the shareholders that poses the greatest concern. Consider the calamitous implications of the shareholders unexpectedly becoming personally liable for the tax bills of the corporation; or for the court judgments against the corporation; or for the other bills of the corporation. Such results can occur if the corporation and its shareholders fail to honor the continuing obligations of corporate formality imposed by Arizona law.

So how does a corporation go about losing its protections? Most usually, when a dispute arises, especially in a corporation with few shareholders, the fiction of the corporate entity may be disregarded and the shareholders may be held personally liable for corporate debts because of the manner in which the shareholders dealt with the corporation. For example, the shareholders had been using the corporation’s bank accounts as their personal piggy bank; the shareholders commingled personal and corporate assets; the shareholders never elected directors or appointed officers; the corporation failed to file annual reports; the corporation was undercapitalized at inception; etc. In such instances, the corporate veil may be "pierced" and the individual shareholders may be subject to personal "alter ego liability."

"Alter ego liability" is a drastic remedy in which the corporate liability passes thorough to the shareholders, whose personal assets are now subject to corporate creditor claims. If the corporations’ separate legal identity has not been maintained, shareholders may be treated as partners and held jointly and severally liable for the debts of the corporation. Thus, in order to protect the financial interests of its shareholders, it is important that a corporation maintain its separate identity.

The following are some basic tips that should help to preserve corporate integrity and help defend any allegations of "alter ego liability" against the shareholders:

• Contribute sufficient capital upon issuance of the stock;
• Be sure to complete the legal formation of the corporation;
• Adopt bylaws;
• Maintain a proper corporate binder, complete with stock ledger;
• Do not use corporate money for personal use unless the corporation legitimately books the withdrawals as salaries or dividends;
• Do not commingle corporate funds with personal funds;
• Hold annual shareholder meetings;
• Hold annual director meetings;
• File Arizona Corporation Commission Annual Reports and Certificates of Disclosure;
• Appoint officers annually;
• Elect directors annually;
• Keep good corporate minutes;
• File all required tax forms, both state and federal.

Arizona corporate law and most standard corporate bylaws permit corporate shareholders and directors to take action and make decisions by unanimous written consent. If the shareholders agree by unanimous written consent, the corporation can usually dispense with annual or other special meetings. However, if the shareholders and directors of a corporation do not agree on corporate issues, and meetings by written consent are not possible, it remains essential that the corporation conduct proper meetings.

In short, ensuring proper and complete corporate formation, maintaining separate corporate finance, and complying with corporate formalities are essential steps to take to protect corporate shareholders’ personal assets. Although Arizona law places certain continuing requirements on corporations, the tradeoff is the persistence of the corporate fiction as a shield against personal liability.

ABOUT THE AUTHOR: Gary Michael Smith, Esq. is an owner of Smith & Craven, P.L.L.C., a law firm whose primary practice focus is the construction industry. Mr. Smith has more than 10 years experience in complex commercial and construction litigation; is co-author of the 2002 book, Construction Lien Law in Arizona; and in May 2003 published his second construction industry book, The Orange Book, Practice and Procedure Before the Arizona Registrar of Contractors and Office of Administrative Hearings. Mr. Smith is licensed to practice law in the Courts of Arizona, Colorado, New York and North Carolina. To contact Gary Michael Smith call 480-222-2225, or visit www.smithcraven.com or www.roclawyer.com.