Behind the corporate veil

An important consideration in starting a business is whether to form it

as a corporation.

Organizing a business as a corporation offers many advantages. For example,

the ability to sell stock can be a significant help when raising capital.

Using a corporate form ordinarily will insulate the owners from direct liability

for the company's obligations, because the corporation is considered to

be a separate legal identity, independent of its owners.

But organizing a business as a corporation can have several disadvantages.

Most notably, using the corporate form can result in double taxation on

income. Because the corporation is an independent legal entity, it may be

required to pay income taxes on its profits. Then, when the proceeds are

distributed, the owners pay taxes on their own personal income.

Another disadvantage is accommodating the many rules imposed by state

laws. These "corporate governance" rules cover things such as board of directors

meetings, capitalization requirements and reporting requirements. Complying

with those procedural restrictions can reduce efficiency.

Still, it is crucial to follow those procedures. In some situations,

when a court believes that the owners have failed to comply with those rules,

it can hold the owners responsible directly for the obligations of the corporation.

This is called "piercing the corporate veil."

Different courts take somewhat different approaches to this issue, although

they typically end up in about the same place. Generally speaking, the corporate

form may be disregarded and the owners held directly liable when: the owner/parent

dominates the operations of the corporation/subsidiary; the arrangement

is used to commit a fraud or other wrong; and a third party is damaged as

a result.

This is more likely when the corporation/subsidiary has been undercapitalized

or when the owner/parent fails to keep proper records or otherwise fails

to observe corporate formalities.

In theory, the same rules apply to government contracting. In practice,

there is sometimes an even greater tendency to disregard the corporate

form in those situations.

Thus, for example, a corporation may be treated together with its affiliates

in determining whether it is a responsible contractor.

Also, all of the affiliates are taken together when determining whether

a company complies with applicable size standards. See, for example, Goff

Corp. Moreover, government agencies often seek to disregard the separate

nature of corporate entities when collecting contractor debts. See, for

example, National Security Service Co.

Although using a corporate form for doing business can provide many advantages,

investors who use this approach must be careful to follow the rules to maintain

those advantages.

—Peckinpaugh is corporate counsel for DynCorp, Reston, Va., and formerly

a member of the government contracts section for Winston & Strawn, Washington,