16.3 Corporations: Formation, Governance, Fiduciary Duties & Corporate Formalities
Key Takeaways
- A corporation is an independent legal person possessing separate legal existence, perpetual succession, centralized board governance, freely transferable shares, and limited shareholder liability, established by filing Articles of Incorporation with the Secretary of State.
- Under federal tax law, C-corporations are subject to double taxation on entity profits (Form 1120) and shareholder dividend distributions (Form 1040), while qualifying S-corporations pass net earnings directly to shareholders, subject to strict limits: maximum 100 shareholders, one class of stock, and individual U.S. citizen/resident alien owners.
- Corporate governance adheres to a strict tri-part hierarchy: shareholders elect directors and approve fundamental corporate changes; the Board of Directors establishes policy, declares dividends, and selects officers; and corporate officers execute daily operations as executive agents.
- Directors and officers owe fiduciary duties of care and loyalty; the Business Judgment Rule (BJR) provides a powerful presumption shielding directors from personal liability for decisions made in good faith, on an informed basis, and without conflicts of interest, unless rebutted by gross negligence, bad faith, or self-dealing.
- Under the equitable doctrine of piercing the corporate veil, courts disregard the corporate liability shield to hold shareholders personally liable when the entity is the mere alter ego of owners, was grossly undercapitalized at inception, or failed to maintain corporate formalities and commingled assets to perpetrate fraud or injustice.
16.3 Corporations: Formation, Governance, Fiduciary Duties & Corporate Formalities
[!NOTE] NALS PP Exam Blueprint Focus: Corporate law and governance procedures are intensely tested on the NALS Professional Paralegal (PP) Certification Exam (Part 4: Advanced Substantive Law). Paralegals must demonstrate total command over the core attributes of corporate personhood, calculate S-Corporation eligibility criteria under IRC § 1361, prepare corporate charters and bylaws, trace the tri-part governance hierarchy, apply the Business Judgment Rule under the Duty of Care (Smith v. Van Gorkom), analyze interested director safe harbors under DGCL § 144 / MBCA § 8.62, and identify the evidentiary factors required to pierce the corporate veil (Walkovszky v. Carlton).
The corporation is the most enduring and commercially powerful entity form in American legal history. First characterized by Chief Justice John Marshall in Trustees of Dartmouth College v. Woodward, 17 U.S. 518 (1819), as "an artificial being, invisible, intangible, and existing only in contemplation of law," the modern business corporation is an independent legal institution governed by state corporate statutes—most notably the Model Business Corporation Act (MBCA) (adopted in whole or substantial part by more than 30 states) and the Delaware General Corporation Law (DGCL), which sets the national standard for major commercial enterprises.
Essential Attributes of the Corporate Entity
A corporation possesses five foundational legal characteristics that distinguish it from unincorporated business organizations:
- Separate Legal Personhood: The corporation is a legal entity distinct from its human shareholders, directors, and officers. It has the legal capacity to enter into binding contracts, own real and personal property, sue and be sued in its own corporate name, incur debt, and enjoy certain constitutional protections (such as due process, equal protection, and First Amendment commercial speech).
- Perpetual Succession (Perpetual Existence): The life of a corporation is not tied to the lifespan of its owners. The death, withdrawal, bankruptcy, or mental incapacity of a shareholder, director, or executive does not dissolve the corporation. It continues uninterrupted until voluntarily dissolved or administratively terminated by the state.
- Limited Liability for Shareholders: Shareholders risk only the funds they have invested in purchasing shares of stock. Under normal circumstances, a shareholder's personal assets are completely insulated from corporate debts, judgments, and tort obligations.
- Centralized Management: Corporate governance is centralized in a specialized governing board (the Board of Directors) and executive officers, separating capital investment from day-to-day managerial operations.
- Free Transferability of Shares: Ownership interests are represented by standardized shares of capital stock, which can be transferred, sold, pledged, or gifted without requiring the consent of other shareholders or dissolving the entity (subject to lawful private shareholder agreements in closely held firms).
Entity Tax Classifications: C-Corporations vs. S-Corporations
For federal income tax purposes, corporations fall into two distinct statutory categories under the Internal Revenue Code (IRC):
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| C-Corporation vs. S-Corporation Tax Comparison |
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| Dimension | C-Corporation (Subchapter C) | S-Corporation (Subchapter S) |
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| Federal Tax Model | Double Taxation: Entity-level | Pass-Through Taxation: No |
| | corporate tax (Form 1120) + | entity-level tax (Form 1120-S); |
| | shareholder dividend tax (Form 1040)| profits flow to Form 1040 (K-1). |
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| Shareholder Limits | Unlimited number of shareholders. | Maximum 100 shareholders |
| | | (family members treated as one). |
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| Eligible Shareholders | Any person or entity: individuals, | Only natural persons (U.S. |
| | partnerships, LLCs, corporations, | citizens or resident aliens), |
| | trusts, and foreign entities. | estates, and qualified trusts. |
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| Stock Class Restrictions | Multiple classes permitted (common, | ONE class of stock permitted |
| | preferred, cumulative, non-voting). | (voting differences allowed). |
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| Election Formalities | Default statutory classification | Form 2553 filed within 2.5 months|
| | upon incorporation. | with UNANIMOUS shareholder vote. |
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Strict Statutory S-Corporation Eligibility Criteria (IRC § 1361)
To qualify and maintain an election under Subchapter S of the Internal Revenue Code, a corporation must satisfy five non-negotiable statutory requirements:
- Domestic Entity: It must be an eligible domestic corporation organized under federal or state law;
- Shareholder Cap: It may have no more than 100 shareholders (spouses and lineal family members are treated as a single shareholder under IRC § 1361(c)(1));
- Eligible Owners Only: All shareholders must be individuals, estates, or certain qualified trusts (such as an Electing Small Business Trust). Corporations, partnerships, LLCs, and non-resident aliens are strictly disqualified from holding shares;
- One Class of Stock: It must not have more than one class of stock. Under Treas. Reg. § 1.1361-1(l), differences in voting rights among shares of common stock are permissible, but dividend rights and liquidation preferences must be strictly identical across all outstanding shares;
- Unanimous Shareholder Consent: All shareholders must execute and consent to the election on IRS Form 2553, filed within two months and fifteen days of the beginning of the tax year or at any time during the preceding year.
Corporate Formation Mechanics & Initial Formalities
Corporate formation requires precise compliance with statutory procedures. Paralegals bear substantial responsibility for drafting corporate charters, preparing organizational minutes, and maintaining the corporate minute book.
1. Articles of Incorporation (Certificate of Incorporation / Charter)
A corporation comes into existence when its Articles of Incorporation (or Certificate of Incorporation in Delaware) are formally accepted and filed by the Secretary of State (MBCA § 2.03):
- Mandatory Statutory Terms (MBCA § 2.02):
- Distinct corporate name containing a statutory corporate indicator ("Corporation," "Incorporated," "Company," "Limited," or abbreviations such as "Corp.," "Inc.," "Co.," "Ltd.");
- The number of shares the corporation is authorized to issue, par value (if applicable), and description of classes;
- Street address of initial registered office and name of registered agent;
- Name and address of each incorporator.
- Discretionary Terms:
- Delaware § 102(b)(7) Exculpatory Provision: A clause eliminating or limiting the personal monetary liability of directors to the corporation or its shareholders for breaches of the Duty of Care (cannot eliminate liability for breaches of duty of loyalty, acts in bad faith, or intentional misconduct);
- Preemptive rights provisions;
- General purpose clause (e.g., "engaging in any lawful business for which corporations may be organized").
2. Defective Formation Doctrines
If an organizer fails to comply with statutory incorporation procedures, courts resolve third-party liabilities using three common law doctrines:
- De Jure Corporation: Created when there has been substantial compliance with all mandatory statutory conditions precedent. Its legal existence is invulnerable to attack by any party, including the state.
- De Facto Corporation: Recognized when there has been: (1) a valid state incorporation statute, (2) a bona fide, good-faith attempt to organize under the statute, and (3) actual exercise of corporate powers. The entity is treated as a valid corporation against all third parties, vulnerable only to a direct quo warranto proceeding initiated by the State Attorney General.
- Corporation by Estoppel: An equitable rule holding that a third party who dealt with an enterprise as if it were a corporation is estopped from denying its corporate existence to hold officers or shareholders personally liable. Similarly, an enterprise that held itself out as a corporation is estopped from denying existence to escape liability.
3. The Organizational Meeting
Following filing, the initial directors named in the charter (or the incorporators if no directors were named) hold an Organizational Meeting (MBCA § 2.05) to complete formation:
- Adoption of initial Corporate Bylaws;
- Election of permanent Board of Directors (if meeting held by incorporators);
- Appointment/election of corporate officers (President/CEO, Vice Presidents, Corporate Secretary, Treasurer/CFO);
- Approval of stock certificate forms and official corporate seal;
- Authorization of initial share issuances and acceptance of stock consideration (cash, property, services);
- Authorization of bank accounts and designation of authorized signers;
- Approval of S-corporation election (Form 2553) and IRC § 1244 Small Business Stock qualification (granting ordinary loss treatment up to statutory caps if shares become worthless).
4. Corporate Bylaws: Internal Governance Rules
The Bylaws serve as the operating manual of the corporation. Unlike the Articles of Incorporation, bylaws are not filed with any public agency. They detail:
- Annual shareholder meeting date, notice periods (e.g., 10 to 60 days before meeting), and quorum requirements (typically a majority of voting shares present in person or by proxy);
- Board of Director composition, election procedures, regular/special meeting notice, quorum, and voting rules;
- Board committee structures (Executive, Audit, Compensation, Nominating committees);
- Officer duties, tenure, and removal mechanisms;
- Share transfer restrictions, stock ledger rules, and indemnification procedures for officers and directors.
- Hierarchy: Statutory Law > Articles of Incorporation > Bylaws > Board Resolutions.
Corporate Capital Structure: Shares & Classes
A corporation's capital structure defines how equity ownership and risk are divided:
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| Classifications of Corporate Capital Stock |
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| Term | Definition & Operational Rule |
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| Authorized Shares | The maximum number of shares the corporation is legally permitted to |
| | issue under its Articles of Incorporation. Cannot be exceeded without a |
| | formal charter amendment approved by shareholders. |
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| Issued Shares | Shares that have been sold, issued, and distributed to shareholders. |
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| Outstanding Shares | Issued shares currently held by shareholders. ONLY outstanding shares |
| | possess voting power and are entitled to receive dividends. |
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| Treasury Shares | Previously issued shares that have been repurchased or reacquired by the |
| | corporation. Treasury shares do NOT vote and do NOT receive dividends. |
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Common Stock vs. Preferred Stock
- Common Stock: Represents residual equity ownership. Common shareholders possess ultimate voting rights (electing directors, approving mergers), but sit last in liquidation priority upon dissolution and receive dividends only after all debt and preferred dividends are satisfied.
- Preferred Stock: Holds statutory or contractual preferences over common stock, typically including:
- Dividend Preference: Must be paid an agreed dividend before any dividend can be distributed to common shareholders. Dividends may be cumulative (unpaid dividends accumulate as arrearages that must be fully cleared in future years before common shares receive dividends) or non-cumulative.
- Liquidation Preference: Fixed monetary priority (e.g., return of original purchase price plus accumulated unpaid dividends) upon corporate dissolution before any proceeds reach common shareholders.
- Voting Rights: Preferred stock is traditionally non-voting, though special voting rights frequently trigger if preferred dividends fall into arrearages.
The Tri-Part Corporate Governance Hierarchy
American corporate governance operates under a strict separation of powers divided among three distinct tiers:
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| The Tri-Part Corporate Governance Model |
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| Tier | Composition & Powers |
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| 1. Shareholders | Equitable owners of the corporation. |
| (Owners) | - Elect and remove members of the Board of Directors; |
| | - Amend Corporate Bylaws; |
| | - Vote on FUNDAMENTAL CORPORATE CHANGES: Mergers, share exchanges, |
| | dissolution, sale of substantially all assets, charter amendments. |
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| 2. Board of | Centralized governing and policymaking body. |
| Directors | - Sets long-term strategic direction and corporate policy; |
| (Managers) | - Selects, supervises, evaluates, and removes executive corporate officers;|
| | - Declares dividends and authorizes share issuances; |
| | - Approves major commercial contracts and capital borrowings. |
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| 3. Corporate | Day-to-day operational managers and executive agents. |
| Officers | - Appointed by the Board of Directors (CEO, President, Secretary, CFO); |
| (Agents) | - Manage daily business operations and supervise rank-and-file employees; |
| | - Possess actual and apparent agency authority to bind the corporation. |
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Shareholder Rights & Remedies
- Inspection Rights: Under MBCA § 16.02, shareholders possess the statutory right to inspect corporate books, records, minutes, and shareholder lists during normal business hours, provided the inspection is for a proper purpose reasonably related to their interest as an investor (e.g., investigating alleged mismanagement, evaluating share value, or soliciting proxies; harvesting lists to sell commercial products is an improper purpose).
- Shareholder Lawsuits: Direct vs. Derivative:
- Direct Lawsuit: Initiated by a shareholder in their individual capacity to enforce a personal right (e.g., suit to enforce voting rights, compel inspection of books, or enforce dividend payment after declaration).
- Derivative Lawsuit: Initiated by a shareholder on behalf of the corporation to recover damages for an injury inflicted upon the corporation itself (e.g., suit against directors for breach of fiduciary duty of care or loyalty). Procedural prerequisites:
- Contemporaneous Ownership: Plaintiff must have owned stock at the time the wrongful act occurred;
- Demand on Board: Plaintiff must make written demand on the Board of Directors commanding them to institute suit, unless demand is excused as legally futile (e.g., a majority of directors are conflicted interested parties);
- Special Litigation Committee (SLC): The board may appoint an independent SLC of disinterested directors; if the SLC conducts a good-faith investigation and determines suit is not in corporate best interests, courts generally dismiss the derivative action under the Business Judgment Rule.
- Dissenters' Rights (Appraisal Rights): Shareholders who object to a fundamental corporate transaction (e.g., cash-out merger, consolidation, sale of substantially all assets) possess statutory appraisal rights under MBCA Chapter 13. By strictly following procedural notice and voting against the deal, the dissenting shareholder can compel the corporation to purchase their shares for fair cash value determined through a judicial appraisal proceeding.
Fiduciary Duties: Duty of Care & The Business Judgment Rule
Directors and officers occupy a fiduciary position demanding utmost integrity. State law divides fiduciary obligations into the Duty of Care and the Duty of Loyalty.
1. The Duty of Care (MBCA § 8.30)
Under MBCA § 8.30, a director or officer must discharge their duties:
- In good faith;
- With the care that an ordinarily prudent person in a like position would exercise under similar circumstances; and
- In a manner they reasonably believe to be in the best interests of the corporation.
Reliance on Experts (MBCA § 8.30(e)): In discharging the duty of care, a director is legally entitled to rely in good faith on reports, opinions, financial data, and statements prepared by corporate officers, legal counsel, independent certified public accountants, or designated board committees.
2. The Business Judgment Rule (BJR)
The Business Judgment Rule (BJR) is the cornerstone of American corporate jurisprudence. It is a rebuttable judicial presumption that in making a business decision, directors acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company.
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| The Business Judgment Rule (BJR) Matrix |
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| Core Presumption: Courts will NOT second-guess business decisions or impose personal monetary |
| liability on directors for decisions that resulted in disastrous financial losses, provided the |
| decision was made in good faith, without self-dealing, and through a diligent decision process. |
| |
| How a Plaintiff Overcomes (Rebuts) the BJR Presumption: |
| 1. Gross Negligence in the Process: Proving the board approved a major transaction without |
| informing themselves of material financial facts (Smith v. Van Gorkom). |
| 2. Bad Faith: Showing intentional dereliction of duty or conscious disregard of corporate welfare|
| (In re Caremark International Inc. Derivative Litigation - failure of oversight). |
| 3. Self-Dealing / Conflict of Interest: Showing directors possessed a material personal financial |
| interest in the transaction (shifts burden to directors to prove entire intrinsic fairness). |
| 4. Illegality: Approving actions that violate criminal or statutory law. |
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[!IMPORTANT] Landmark Precedent — Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985): The Delaware Supreme Court held that the Board of Directors of Trans Union Corporation breached their fiduciary duty of care by approving a $690 million cash-out merger after a two-hour meeting. The directors did not read the merger agreement, received no investment banker valuation report, and relied solely on a 20-minute oral presentation by the CEO. The court ruled that the Business Judgment Rule did not protect the board because they were grossly negligent in failing to inform themselves of all material facts reasonably available to them before making the decision. (This ruling spurred widespread adoption of DGCL § 102(b)(7) exculpatory charter clauses).
Fiduciary Duties: Duty of Loyalty & Safe Harbors
The Duty of Loyalty mandates undivided allegiance to the corporation. A director or officer cannot utilize their corporate position to advance personal financial interests at the expense of the enterprise.
1. The Corporate Opportunity Doctrine
A corporate fiduciary cannot usurp for personal gain a business opportunity that belongs to the corporation. Under the landmark decision Guth v. Loft, Inc., 5 A.2d 503 (Del. 1939), an opportunity belongs to the corporation under the Line-of-Business Test if:
- The corporation is financially able to undertake the opportunity;
- The opportunity is within the corporation's line of business;
- The corporation has an interest or reasonable expectancy in the opportunity; and
- By embracing the opportunity, the self-interest of the fiduciary will be brought into conflict with that of the corporation.
- Safe Harbor: A fiduciary may take a corporate opportunity only if they first disclose all material facts to the board and the disinterested directors formally reject the opportunity on behalf of the corporation.
2. Interested Director Transactions & Statutory Safe Harbors
An interested director transaction (self-dealing) occurs when a director is a party to a contract with the corporation (e.g., selling real estate they personally own to the corporation), or has a material financial interest in a counterparty entity. Under modern statutes (such as DGCL § 144 and MBCA § 8.62), an interested director transaction is NOT void or voidable solely due to the conflict if any one of three statutory safe harbors is satisfied:
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| Interested Director Transaction Safe Harbors (DGCL § 144) |
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| Safe Harbor 1: Disinterested Director Approval |
| - The material facts regarding the director's interest and the contract are fully disclosed or |
| known to the Board of Directors; AND |
| - The transaction is approved in good faith by a majority of the DISINTERESTED directors, |
| even if the disinterested directors constitute less than a formal board quorum. |
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| Safe Harbor 2: Shareholder Approval |
| - The material facts regarding the conflict are fully disclosed to shareholders; AND |
| - The transaction is approved in good faith by a vote of the shareholders. |
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| Safe Harbor 3: Intrinsic Fairness (Judicial Review) |
| - If approval by disinterested directors or shareholders was not obtained, the interested |
| director bears the affirmative burden of proving that the transaction was INTRINSICALLY FAIR, |
| reasonable, and yielded commercial fair market value to the corporation at the time authorized. |
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Piercing the Corporate Veil: The Walkovszky Factors
Piercing the Corporate Veil is an equitable doctrine wherein a court disregards the corporation's separate legal personhood and holds individual shareholders personally liable for corporate debts, contract defaults, or tort judgments.
Veil piercing is an extraordinary judicial remedy applied reluctantly. Courts require proof that the shareholder exercised complete control to perpetrate a fraud, injustice, or evade legal obligations. Under the landmark decision Walkovszky v. Carlton, 18 N.Y.2d 414, 223 N.E.2d 6 (1966), and its progeny, courts evaluate four primary evidentiary prongs:
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| Four Pillars of Corporate Veil Piercing |
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| Evidentiary Factor | Operational Manifestations & Practical Evidence |
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| 1. Alter Ego / Mere | The corporation ceases to have a separate identity; the dominant |
| Instrumentality | shareholder treats corporate assets as their own "pocketbook"; total |
| | unity of interest, ownership, and unconstrained control. |
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| 2. Commingling of Funds | Blending personal and corporate bank accounts; paying personal credit |
| and Assets | cards, residential mortgages, or vacations from corporate accounts; |
| | making undocumented loans between entities without promissory notes. |
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| 3. Gross Undercapitalization| Forming the corporation with shockingly inadequate equity capital |
| at Inception | and insurance relative to the foreseeable risks and debts of the |
| | business enterprise. |
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| 4. Failure to Observe | Failing to hold annual shareholder or board meetings; failing to keep |
| Corporate Formalities | minutes of meetings; failing to issue stock certificates; having |
| | directors act as mere rubber stamps without independent oversight. |
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[!CAUTION] Contract vs. Tort Creditors: Courts are significantly more inclined to pierce the corporate veil on behalf of an involuntary tort victim (e.g., a pedestrian run over by a grossly undercapitalized delivery truck) than on behalf of a voluntary commercial contract creditor (e.g., a commercial bank or commercial landlord). Voluntary creditors had the advance opportunity to examine financial disclosures, conduct credit checks, and require the shareholder to sign a personal guarantee before extending commercial credit.
A small medical manufacturing corporation with 80 shareholders intends to elect pass-through taxation under Subchapter S of the Internal Revenue Code. The company's capitalization consists of 500,000 shares of Voting Common Stock and 200,000 shares of Non-Voting Common Stock. All economic rights, including dividend payments and liquidation distributions, are strictly identical across both classes. One of the prospective investors wishing to purchase 1,000 shares is a Canadian citizen residing permanently in Toronto who is neither a U.S. citizen nor a U.S. resident alien. Can the corporation successfully elect and maintain S-Corporation status under IRC § 1361?
A director of a commercial logistics corporation personally owns an unencumbered suburban parcel of industrial land. The corporation is actively seeking a location for a new regional distribution warehouse. The director offers to sell the parcel to the corporation for $2.5 million. Before any vote, the director fully discloses their personal ownership, original acquisition cost of $1.8 million, and a recent certified independent appraisal valuing the parcel at $2.6 million. The full Board consists of five directors. The interested director recuses themselves from voting, and the remaining four disinterested directors vote unanimously to approve the land purchase. If a minority shareholder files a derivative lawsuit alleging breach of the fiduciary duty of loyalty, what is the legal effect of the board's approval under DGCL § 144?
A sole shareholder forms a commercial demolition corporation with $1,000 in initial stated capital, carrying only the minimum statutory state automobile liability insurance. The shareholder maintains no corporate minute book, holds no shareholder or director meetings, pays personal home mortgage payments and personal grocery bills directly out of the corporate checking account, and makes undocumented, interest-free transfers between the company and their personal bank account. During a demolition project, an employee negligently collapses a masonry wall onto a parked tour bus, causing $1.5 million in property damages. The corporation has only $15,000 in net assets. If the tour bus owner seeks to collect the judgment from the shareholder personally, what equitable doctrine will the court apply, and what is the likely outcome?