Author: Warren Ragoonanan
We have noticed a bit of a trend. Routinely, entrepreneurs come to us having incorporated, but not having organized, their corporations. We talk about the organizing process quite a bit in some of other WRD of Mouth entries (in particular, see The 7 Key Steps for Incorporation and Incorporation Documents). Without repeating too much of what has already been said, some of the particularly important parts of organizing include enacting by-laws, issuing shares, electing your first Board of Directors, appointing officers, and setting your fiscal year end. It also includes enacting a shareholder agreement if you have two or more shareholders. These are all the parts that make up the corporation’s Minute Book.
It is a given that for most new businesses, money is tight. Founders tend to do a lot of work themselves, and that includes their own legal work. The temptation is strong, Especially because the Corporations Canada Online Filing Centre is so easy to use. Frequently, we see founders skipping organization entirely. Even if they are aware of the requirements, founders may ignore them until they become necessary. Or even worse, founders may look for boilerplate documents on the internet and try to be their own lawyer.
As an alternative, I have seen several do-it-yourself incorporation websites pop up. They are popular because they appeal to the scrappy DIY spirit of the average business founder. These sites promise incorporation and organization at a low price. Some of WRD’s clients take advantage of these before coming to us. You know what we haven’t seen? A proper set of organizing documents from these sites. We have always found mistakes. Today, as I write in October of 2021, you still need a human lawyer to advise on and draft organizing documents. It is just not possible using today’s technology to program a site that can capture the nuance and judgement used by a lawyer during this process. I have no doubt that artificial intelligence technology will advance to the point where a site can do a corporate organization quickly and cheaply, without human intervention. But we aren’t there yet.
A missing, or incorrect organization is a major problem. What compounds that problem is that there are rarely any immediate consequences for not organizing. Years, and even decades, can go by without anything happening. And then one day, you are trying to do a major transaction and, surprise, you step on this legal landmine. Take the following scenarios:
- Selling Your Business: A common way to sell your business is to sell the shares. Sellers of a business may prefer a share sale because they can simply hand over the reins on an “as-is” basis rather than parceling out assets and dealing with any remaining loose ends themselves. Also, with proper planning, selling shares can allow sellers to take advantage of a certain exemptions to capital gains tax in the Income Tax Act (Canada). However, if shares were never issued in the first place, there is a big problem. Buyers cannot evaluate what they are buying, and sellers do not know what they are selling. You can’t sell what doesn’t exist.
- Bringing in a Partner: We have encountered many business owners who run the business themselves, but then want to provide an equity stake to a new shareholder. It could be a key employee, or it could be a son or daughter they are hoping will take over after they retire. Some of our clients even want to set up formal employee share ownership plans to retain key talent, and foster growth. These are all great ways to expand your business. But if shares were never issued, those transactions run into a problem. Again, you can’t sell shares that don’t exist.
- Managing a Tax Audit: Canada Revenue Agency normally wants to see your tax receipts and financial records during an audit. However, we have seen cases where they want to look at minute books. They want to make sure that corporations have properly declared dividends and prepared the necessary minutes or resolutions. If no shares exist, then explaining those dividends to CRA will be challenging.
- Defending a Lawsuit: When you incorporate, owners are supposed to enjoy limited liability. The idea is that the corporation is sued in its own right, and only the assets belonging to the corporation have liability exposure. However, limited liability only applies to shareholders (see section 25(1) of the Canada Business Corporations Act, and section 92(1) of the Business Corporations Act (Ontario)). If a business owner was never issued shares, there is an argument that there are no shareholders, and no one involved in the business should have limited liability. That would make the owner personally liable for the obligations of the business, as if they were a sole proprietor. This concept is known as “piercing the corporate veil”. The cases that involve veil-piercing are complicated, and well beyond the scope of this piece. The key takeaway is that this is a non-issue if the corporation is properly organized.
When problems like the ones canvassed above come up, the owner is forced to get their corporation organized and updated in a rush. We see this problem a lot. When we encounter it, we need to review the filings and tax returns, and then rebuild the corporate records from scratch. It is a time-consuming and expensive undertaking. It can be frustrating, especially when the failure to organize holds up some other transaction by months or weeks.
What do I mean you aren’t organized? I mean that you have missed a major step in setting up your corporation. It is a step that you cannot skip. Get it done when you incorporate. It may cost a little more now, but that is likely much less than what you would pay us to fix it later.