What is the Purpose of your Corporation? – A Brief Look at the Doctrine of Ultra Vires

Many states have created a standardized document for forming a legal entity. These standardized forms were created partly to prevent lawyers from drafting and submitting extremely long incorporation documents and partly as a way to create ease of use for the general public. Most standardized forms contain a section for the name of the entity, the name of the resident agent, the name of the officers and/or directors, and a section for the corporate purpose.

We are going to take a closer look at the “purpose” section of an entity formation document. Today, lawyers generally use broad language such as, “any lawful purpose” in the purpose section of these documents. However, such was not the case many years ago. Incorporation documents used to be drafted with a very specific corporate purpose. As such, the doctrine of ultra vires was created by the courts. The doctrine of ultra vires was the cause of much litigation and judicial interpretation. The dictionary definition of ultra vires is “beyond the legal power or authority of a corporation, corporate officer, etc.” It is important to note that this doctrine, although traditionally applied to corporations, applies to all types of legal entities.

In plain terms, the doctrine of ultra vires applied to the “purpose” of corporate formation. For example, if a corporation was formed for the purpose of laying railroad tracks, that corporation could not engage in any other business. This makes sense if you think about it, but you can only imagine the limitations such a doctrine creates in this modern age. Today, corporations engage in so many different types of businesses and investments that if this doctrine was statutory majority law, instead of common law minority, you would see many more lawsuits due to a company’s participation in an enterprise that was not originally committed to paper in that pesky “purpose” section in the articles of incorporation.

The ultra vires doctrine was used both by the corporations and by other contracting parties. The problem with this doctrine is that it was easy to abuse. For example (using the same railroad laying track example above), if a corporation stated on its articles of incorporation that its purpose was to lay railroad tracks, the corporation was limited to pursuing only that business. Let us say that this corporation entered into a contract to manufacture railroad tracks. According to the doctrine of ultra vires, the corporation was prohibited from doing this. However, a court could only get involved if one of the parties complained. Therefore, as long as everybody got along, it technically did not matter that the corporation was conducting business beyond the limits of its stated purpose.

However, problems arise when a party wants out of the contract. For example, let us say that the railroad laying company is losing money on the contract for the manufacturing of railroad tracks. If the company wanted, it could get out of the contract by using the doctrine of ultra vires. It could argue that although it freely entered into the contract, it could repudiate the contract by stating that the doctrine of ultra vires prevented it from performing under the contract (in other words, the corporation was prohibited from manufacturing railroad tracks). The irony of this is that the other party that entered into the contract could assert the same thing if he/she/it wanted out of the contract. Basically, both parties in this example had a sure fire way out of a losing contract.

The dangers, pitfalls, and areas of abuse were wide. Additionally, you could see how this doctrine could create very unjust results. Two parties that freely entered into a contract could essentially screw the other if one was losing money. Due to this inherent unfairness, the doctrine has fallen out of favor. However, the doctrine is not nonexistent.

Lawyers combat this doctrine by creating a very broad “purpose” section. For example, as I stated above, usually lawyers use the “any lawful purpose” language when drafting a purpose section. However, you must be careful. Some state laws prevent the use of such broad language. Additionally, using broad language is not a guarantee against a lawsuit. Your safest bet is to know your local laws, draft broad purpose statements, and write a solid contract. So, for all of you entrepreneurs that want to form a legal entity, make sure your draft your articles correctly and carefully because something as simple as a “purpose” section can end up destroying a future contract!

Piercing the Corporate Veil

Piercing the corporate veil is a fancy phrase that means that somebody or something is attempting to hold the shareholders of a corporation personally liable for the corporation’s debts. Veil piercing is not an easy task and requires many factors to be proven. The main inquiry is, “has the corporate form is being misused?” If it is concluded that the corporate form is being misused, the court will disregard the corporate entity and hold the shareholders personally liable.

Each state has different factors that in considers in determining whether to pierce the corporate veil. It would be inefficient to list all the various laws from all fifty (50) states, however, I will discuss some common factors.

Undercapitalization is a commonly considered by most states. Undercapitalization means that the corporation was not equipped with a reasonable amount of capital for the nature of the business involved. What is reasonable? If there was a clear answer to that, there would not be a need for lawyers! Reasonableness depends on many factors including type of business, size of business, etc. If a corporation is undercapitalized, this weighs in favor of the court piercing the corporate veil.

Another commonly considered factor is the failure to observe corporate formalities. Like I stated in previous posts, failure to observe corporate formalities will tip the scales towards the court piercing the corporate veil. Corporate formalities need to be observed by all corporations (except a close corporation).

Lastly, most courts consider whether a corporation was used to promote fraud, injustice, or illegalities. Let me put it this way, if you use the corporation to engage in illegal activity (for example, defraud somebody out of money or other valuables) the court will most likely pierce the corporate veil.

It is important to note that these are just some of the commonly considered factors. Every state has a different set of factors, therefore, check your local laws. Also, no one factor is controlling. Therefore, veil piercing does not turn on the absence or presence of a single factor. Last, even though no one factor is controlling, the factors are not weighed evenly. Factors such as illegal use weigh more than whether or not corporate formalities were observed.

Once again, this post is intended only to give you a brief overview of some corporate issues and in no way constitutes legal advice or a legal opinion. Always consult a professional before attempting anything stated above.

The Corporation

The corporation is probably the mother of all limited liability entities. The case law is vast and the complexities are many. However, a corporation can be a great business form if you know what the differences between the various corporations are.

As I stated in a previous post, corporations are subject to double taxation. A dollar earned by the corporation is taxed once as a corporate earning and then taxed again upon distribution to shareholders. However, this is not true for all types of corporations. An S-corporation (named after sub-chapter S in the relevant IRS code) is a pass-through entity. This means that the corporation is taxed as a partnership. Therefore, no double taxation! Unfortunately, with benefits come disadvantages. I do not have the code book open in front of me, but I think some of these disadvantages include, amongst other things, limitations of the number of investors you can have (I think you can only have seventy-five (75) investors for an S-corporation), and limitations on who can invest (no other entity, such as another corporation or limited liability company, can be a shareholder).

Keep in mind that when you form your corporation with articles of incorporation, filed with your Secretary of State, you do not form an “S-corporation.” Subchapter S status is received from the IRS, not your state! However, some states require that you state your intention to be an S-corp. in your articles of incorporation. Therefore, check your local laws!

A close corporation is the same thing as an subchapter S corporation, but with stricter limitations (for example, I think some close corporations can only have thirty-five (35) investors). A great advantage exists with close corporations. Close corporations do not have to engage in corporate formalities. Why is this important? When somebody sues the corporation and tries to pierce the corporate veil (meaning the claimant is trying to “pierce the veil of limited liability” and hold the shareholders personally liable), one factor, of many, the court considers in determining whether to pierce is whether the corporation engaged in corporate formalities. If a corporation engaged in corporate formalities (conducted annual meeting, recording minutes, etc.) this supports the conclusion that a corporation did not misuse the corporate form and, therefore, is less likely to have its “veil” pierced. If you have a close corporation, corporate formalities do not have to be conducted, and a court cannot hold that against you should any lawsuits arise.

A closely held corporation is a term of art. There is no special filing or advantage to a closely held corporation. A closely held corporation is one in where the shareholders and the directors are the same people. Usually about five shareholders will exist, and each will also be a director, if not also an officer, of the corporation. In case you are wondering, shareholders elect directors and directors elect officers.

This post is intended to give you a brief overview of some of the corporate forms that exist. Like always, check with a professional before trying to form one of these entities by yourself.

The Types of Business Organizations

Business entities can be distinguished into two different categories: (1) unlimited liability entities; and (2) limited liability entities. In order for you to have a better understanding of these various entities, this post will be broken into two parts. This part will discuss unlimited liability entities.

Unlimited liability entities mean that in the even that you get sued, a claimant has the possibility of recovering against all of your assets. You are not personally protected if you form an unlimited liability entity.

Two types of unlimited liability business entities exist: (1) a sole proprietorship; and (2) a general partnership. You may be wondering why somebody would set up one of these entities. If you can be held personally liable for all judgments against your business, what is the advantage of forming one of these? Although a person may be held personally liable, there are some advantages to setting up one of these entities.

First, no filing requirements exist with either of these entities. This is great because you literally save hundreds, if not thousands, of dollars. States require a filing fee and the execution of certain documents for other entities, however, these two unlimited liability entities require neither.

Second, both of these entities are very easy to operate. There are no board of directors, no stock holders, and no other level of management except you. This creates a very easy management situation because you only have you to answer to.

Last, these entities do not have the problem of double taxation. In other words, any money the company makes is not taxed separately from the money is distributes. The money saving tax advantage to this is obvious.

Unfortunately, some negatives exist in forming these types of entities. First, and most obviously, you are unlimitedly liable for all debts and judgments. This can literally financially ruin you.

Second, raising capital can be difficult. You cannot sell shares of stock because there are no shares. Usually, you bring all of the money to the table or you have to take on a partner in order to receive capital.

Last, you cannot transfer your interest in these entities. In other words, you cannot sell your ownership in these companies. The effect of selling your interest is the dissolution of the previously existing entity. For example, if you owned a corporation, you could sell your stock to whomever you want (and thus in effect, sell your ownership interest in that company) without creating a dissolution. The same is not true with these unlimited liability entities.

The previous was just a brief overview of some of the various entities you can form. Do not dive head first into forming a company. Although they offer various business and tax advantages, you will probably want to talk with a lawyer before forming anything.