Common Mistakes Made by Small Business Owners
Business Law Articles
Written By: Eric A. Cruz, Esq.
Bivins & Hemenway, P. A.
Valrico (Tampa), Florida
From the time they formulate their first business idea, and often all the way through dissolution, small business owners throughout the United States often find themselves in situations that they are not familiar or comfortable with. Specifically, throughout the life of their businesses, business owners are faced with a number of situations in which their knowledge of the rules, laws, and regulations affecting their day-to-day business operations and decisions is put to the test. The prudent small business owner seeks legal advice when such situations arise, in order to avoid putting their corporate liability protection at risk. Loss of corporate liability protection can result from a business owner’s failure to follow what are often simple rules and corporate formalities. However, whether it is because of a lack of funds, time-constraint issues, or a misplaced I-can-do-it-myself attitude, many small business owners fail to seek the advice and answers they need, thus opening themselves up to potential personal liability and the piercing of the corporate veil.
This article focuses on common mistakes made by small business owners that are often caused by their failure to understand the legal rules and formalities affecting their business and legal entity of choosing, and is based on first-hand observations made by a business law attorney. When representing or doing business with small businesses, caution is recommended and advised in ensuring that both the owners and the officers or managers of such business entities are not making these simple mistakes that can result in much larger issues down the line.
I. Not forming a separate legal entity
One of the most common mistakes made by small business owners is not forming a separate legal entity at all, and operating as a sole proprietor. Many sole proprietors fail to understand that there is no legal distinction between them and the business – and that they have unlimited personal liability for all business debts and losses. This is especially concerning for businesses in which the owner can be exposed to a high level of liability, especially in those where the personal injury of another person may occur.
A number of sole proprietors legally file for and obtain a fictitious name to operate under, and then open bank accounts under their fictitious name. This may create a false sense of protection because business debts are being paid from the business account; however, the business owner may not understand their personal responsibility for business debts and liabilities, and the fact that they may have to be paid from the personal accounts and assets of the owner.
II. Not understanding the separation between a legal entity and the individual person – “I incorporated myself”
Many small business owners take the first step – after coming up with their business idea, they form a corporation, limited liability company, or other business entity existing within the laws of their state, which they are then able to operate under. But many business owners stop at this first step and do not understand the concept of their corporation or company existing as a separate legal entity or “person” that exists on its own, with its own assets, debts, and ability to enter into contracts, and sue and be sued, among other things. Such misunderstanding can result in the small business owner’s failure to put into effect one of the key advantages they sought out by forming the business entity – corporate protection from personal liability for business debts and liabilities.
A phrase commonly heard from such a business owner is “I incorporated myself” - often uttered when the business owner is telling the tale of their business formation and the reasons why they decided to legally incorporate their business. Frequently, the business owner who uses this phrase has also formed a corporation named after their own name (i.e., “John Doe, Inc.”), which doesn’t own any actual assets or bank accounts, but at the same time incurs debt and opens itself up to liability. This typically occurs because the business owner in this situation attempts to create what they believe to be a “legal shield” from personal liability by “incorporating themselves,” with an incorrect belief that all debts and liabilities incurred under the corporate name cannot become their personal responsibility for any reason. On the other hand, often they may deposit business revenues in the owner’s personal bank account, and pay personal expenses from the business funds and bank accounts as well. Such intermingling of funds and assets of the business entity with those of the owner, and treatment of corporate assets as the business owner’s own, while at the same time failing to keep corporate records and maintain corporate formalities (as discussed in more detail below), can lead to piercing of the corporate veil and potential loss of corporate liability protection, resulting in personal liability for the business owner.
III. Failure to organize and maintain corporate formalities
After legally forming a new business entity by filing their articles of incorporation or articles of organization with the respective and appropriate department in their state, many small business owners believe that they have completed all the steps necessary to operate under their new business entity, and completely ignore many corporate formalities required by statute or other applicable law. Many owners fail to realize that they have yet to name any officers, directors, or managers to manage the day-to-day operations of their new business entity, and sometimes that they have even failed to issue any actual shares or membership interests to themselves and other owners of their business entity. Therefore, such business owners have no evidence of ownership of their entity, and are thrown into panic when asked for the same by a potential lender, insurance agent, or other party doing business with the business owner. Moreover, by failing to name officers or managers, business owners fail to provide for any person with authority to act or make decisions on behalf of the business entity. This can cause issues when the company enters into a contract it is later trying to enforce.
In addition, there are a plethora of additional corporate formalities that often remain ignored by business owners, including, but not limited to: (a) adopting bylaws or an operating agreement setting forth, among other things, rules and guidelines for the operations of the entity, and the authority of officers or managers to act on behalf of the entity; (b) making sure officers and managers are abiding by such by-laws or the operating agreement; (c) holding annual meetings of directors and shareholders or members and recording the decisions made during such meetings (or preparing a written consent in lieu of the same, as authorized by local law); (d) keeping minutes of important decisions made during annual or special meetings of the shareholders and directors or members (or preparing a written consent in lieu of the same, as authorized by local law); (e) preparing and updating a readily-available corporate book with accurate, detailed minutes and other records of the business entity, including evidence of shares or membership interests issued and/or transferred, as well as records of other major actions taken and completed by the business entity (such as shareholder dividends and distributions, issuance of stock, recapitalization, etc.), whether evidenced through meeting minutes or by written consent.
A systematic failure to abide by the corporate formalities referenced above is one of the factors a court may consider when deciding whether or not a creditor may pierce the corporate veil and hold shareholders or members personally liable for business debts entered into by the company. Small business entities are especially vulnerable because the failure to meet such basic corporate formalities gives the appearance of the corporation simply being an “alter ego” of its owner created only to avoid the claims of potential creditors.
IV. Failure to file annual report
Most states require business owners to file annual reports with their respective department of corporations setting forth a summary of information regarding the current status of the business entity. This information often includes the mailing and principal business address of the business entity, the name and address of its resident agent within the entity’s home state, and sometimes, a list of its officer, managers, and/or directors. An annual report also informs the state that the entity is still operating and in business. Entities registered to do business in other states as foreign corporations or companies may also have to file an annual report in such states to comply with foreign entity registration requirements.
After filing their initial articles of incorporation or organization, many business owners forget to file the required annual report in future years. Special attention must be given to each state’s specific annual report requirements, as each state has different, and often very specific, requirements. For instance, some states only require a report to be filed every other year, many have different deadlines and due dates, and the information required to be provided may vary depending on the state. As some business owners may own separate business entities which have incorporated in different states, they can also fail to correctly or timely file their annual report in one of the states because they assume the rules are parallel throughout the entire United States.
Failure to timely and/or correctly file an annual report can lead to harsh penalties against the business entity. Typically, a late fee will be applied towards a late filing (in addition to the original filing fee), and in some states the business entity can be administratively suspended or dissolved by state. Such dissolution may result in the personal liability of officers or managers purporting to act on behalf of the business entity after its dissolution. In addition, reinstatement fees may apply if the business wants to be reinstated and regain good standing with the state.
V. Erroneously signing contracts on behalf of the business entity
The first common mistake made by business owners when entering into business contracts is incorrectly identifying the contracting party. Many small business owners fail to understand the importance of clearly identifying their business entity as the party to all business contracts entered into on behalf of the entity. Otherwise, such contracts may have the appearance of being personal, rather than business, contracts. Business owners sometimes fill in an abbreviated or incomplete name for their entity in the opening of the contract, or even worse, fill in their own personal name as the contracting party.
More commonly, even when correctly naming their company as the party to the contract in the opening section, many business owners will sign just their name with no designation of their title or capacity for the company at the end of the contract. This can create an issue as it becomes unclear whether the business owner signed the contract on behalf of the entity, individually (as a direct party), or perhaps guaranteeing the obligations of the business entity. The issues compound if at the same time the parties were also not clearly identified at the opening, or if the contract refers to “the undersigned,” because then it could appear as if the individual business owner entered into the contract, rather than the entity, and then, in the event of a default under the contract, the business owner would lose his or her corporate liability protection and be subject to personal liability. The name and signature of the small business owner should always be accompanied by the title of the signatory and the name of the company in order to avoid personal liability.
This mistake may often occur in conjunction with another common mistake made by small business owners – when the business owner obtains a fictitious name registration for his or her business entity or operation, but lists him or herself as the owner of the fictitious name, resulting in the fictitious name simply becoming an alias for the owner, individually. This essentially creates a sole proprietorship, which should be avoided in most situations, as explained above. If the business owner enters into any contracts under the fictitious name owned individually, he or she has then entered into each contract personally and individually, without any corporate liability protection.
VI. Fail to plan for company succession
When starting a new business, the last thing a new business owner wants to think about is his or her death or disability, a dispute with a business partner or co-owner, their exit from the business, or other kinds of separation from or the transfer of their business, both voluntary (sale of ownership interest, resignation) and involuntary (judgments, bankruptcy, divorce). These are all common occurrences of events that can cause sudden changes to the ownership structure of a small business which can send it into a whirlwind when a person with no knowledge of the business suddenly finds him or herself in control because of one of the occurrences mentioned above.
Entities without bylaws, operating agreements, or separate shareholder agreements often don’t have a structure in place for dealing with such unplanned or unexpected succession and changes of the ownership of the business, such as stock/membership unit transfer restrictions, rights of first refusal, and/or required approval of new members or shareholders. This is especially important when the business entity is owned by more than one person. In a classic example, when a business owner dies, his or her ownership stake in the business would likely be inherited by their spouse. If the deceased owner has not properly disposed of his ownership interest in the business under his will and/or made no separate agreement with the company as to what would happen with his shares after death, a spouse can immediately step into an ownership and management position within a business, but often the spouse lacks the knowledge, experience, and skills to run the business. Sooner than later, many businesses in this situation fail and are forced to dissolve.
Small business owners need to think through these potential change of ownership events and come up with a plan for the succession of the business should they face them in the future. Some of these situations, such as death, are a certainty. Corporate documents should be amended as necessary, or additional shareholder/buy-sell agreements entered into, to make sure it is clear what processes the remaining owners of the business entity must follow when such situations arise.
VII. Failure to properly dissolve
Last, but certainly not least, when a business has run its course and the business owner makes the decision to formally dissolve it, the owner then simply stops filing annual reports with the division of corporations (or other state specific equivalent) and just allows the business entity to be automatically and administratively dissolved. As previously mentioned, when an entity is administratively dissolved for this reason, there is potential for continuing liability - shareholders, officers, directors, and managers may bear personal liability for acts they take on behalf of the corporation while they know the corporation to be administratively dissolved.
Business owners should pay attention to the dissolution provisions provided by law of their state and also within their corporate documents (such as bylaws or operating agreements) in order to avoid losing their corporate liability protection. If proper procedures are met, and the entity is then formally and legally dissolved according to such procedures, the owners may then avoid potential personal liability for claims against the entity that are not able to be paid from the remaining assets of the business entity at the time of dissolution. Such procedures and requirements often include guidelines regarding the kind of notice that must be given to creditors to let them know of the company’s dissolution and whether or not assets are available for distribution as payment for claims. Therefore, dissolution procedures typically create an opportunity (and sometimes mandatory requirements) for dealing with the remaining creditors of the business entity at the time of its dissolution.
While this brief summary lists some of the most commonly encountered mistakes made by small business owners, it is in no way a comprehensive list of all the potential mishaps, actions, or omissions that could lead to a small business owner’s exposure to personal liability and other business-related issues. When presented with one or more of these mistakes, it is important to understand how the local, applicable laws of the jurisdiction where the business entity was incorporated affect the situation, and what the result and consequences of the same might be, so that the small business owner can understand their current position and what they can do to potentially resolve them. Most importantly, however, is to be vigilant and help small business owners avoid these mistakes before they make them.
Eric A. Cruz is an associate attorney with Bivins & Hemenway, P.A., a full service commercial and real estate law firm located in Valrico, Florida. Eric's practice focuses on business law, real estate transactions, and estate planning.
For more information about Bivins & Hemenway, P.A., please visit www.bhpalaw.com or the International Society of Primerus Law Firms.