Capitalizing a new business entity is a critical step of the formation
process. Failing to take the step can lead to serious legal problems if the
entity is ever sued. So, what is capitalization and what steps must be
taken?
Capitalizing Your
Corporation
“Capitalization” essentially refers to funding your
corporation. In essence, you are providing substance to the entity in the form
of money or property. Typically, the funding process works in two
ways.
Corporate Stock
You must own stock in a
corporation to be considered a shareholder. You are already familiar with this
concept if you trade on the stock market. For instance, assume you bought stock
in Sirius Radio in anticipation of Howard Stern moving to the station. You
purchased stock through a brokerage or retirement vehicle by exchanging money
for shares. Technically, you are a shareholder in the corporation. Your own
corporation is no different.
The fact that you paid money to have a
corporation formed does not make you a shareholder. You must exchange property,
cash or services to obtain stock from the entity. Only then are you a
shareholder in the entity. This is more easily explained with an example.
Assume I start a corporation for the purpose of providing consulting
services to other businesses. The corporation is formed with 10,000 shares and I
am going to be the sole shareholder. I have cash and certain assets that I am
going to use as part of the business. I decide to exchange $3,000, a copier, fax
machine and computer equipment for stock in the entity. This exchange should be
reduced to writing, but will constitute the capitalization of the corporation.
Corporate Loan
You can also loan money to a
corporate entity for start-up costs. There is no prohibition against a
shareholder providing money to a corporation. The loan process should not
completely replace the purchase of stock. From a tax perspective, however,
dividing your initial capitalization into a partial loan can have distinct
advantages.
Inadequate Capitalization
State laws
govern the formation of a corporation. Inevitably, these laws set forth amounts
or formulas for determining the minimum capitalization amount required for a
corporation. You must review the laws in your state to determine the amount and
make sure you meet the contribution minimums.
Failure to properly
capitalize you corporation can result in disaster if the entity is ever sued.
Simply put, the suing party may argue that the lack of capitalization means the
corporation was never a viable entity because it had insufficient funds to back
debt obligations. The argument gets complicated, but suffice to say you are in
serious trouble if a court agrees with the argument. Typically, the court will
“set aside” the corporate entity, exposing each shareholder, director and
officer to the risk of personal liability. Obviously, such a scenario would be a
disaster.
In Closing
If you’ve purchased a
corporation from online service, you have work to do. Make sure you determine
the minimum capitalization requirements in your state and comply with them.
About the Author
Richard A.
Chapo is with SanDiegoBusinessLawFirm.com - This
article is for information purposes only.
