As a new business owner, you know that protecting your personal assets is one of the main reasons for forming a business entity instead of operating as a sole proprietor or a general partnership. So you decided to incorporate your business or you formed an LLC. That’s great. But that’s not the end of it. In order to continue to protect your personal assets from business creditors and claimants, you must maintain your entity’s legal standing. Otherwise, a creditor or claimant could file a lawsuit against you and successfully “pierce the corporate veil” thus opening the door to your personal assets; like your bank account or home.
Entities such as corporations and LLCs provide limited liability protection to their owners, officers and directors. But in certain situations, courts can ignore the limited liability status and hold an individual liable for the business’ debts. When this happens, it’s called piercing the corporate veil. And it typically happens when business owners fail to operate their businesses separate from their own personal financial affairs.
Closely held corporations (a corporation owned by just one or a few people) and small LLCs are most likely to have their corporate veils pierced because these are the people who tend to pay personal bills with their company’s checking account, use business assets for personal purposes or ignore the legal formalities that a corporation or LLC must follow. This gives the appearance that the owners are operating the business as if the legal entity did not exist. It is this failure to follow corporate formalities that I wish to address in this post.
Hold Legal Meetings
Be sure to hold annual meetings of directors and shareholders (for corporations) or members/managers (for LLCs). Corporations have strict formalities that they must follow regarding meetings. And, while there is no statutory requirement for LLCs to hold meetings, observing these formalities is highly recommended as courts are becoming more apt to apply these same types of requirements to LLCs to evidence that they are really businesses.
Every corporation has owners; also referred to as shareholders. And every state requires a corporation to hold at least one meeting of the shareholders each year. This is called the annual meeting. In addition, most every state requires a corporation to have a board of directors. That means that a corporation also needs to hold an annual meeting of the board of directors as well. Now, in the case of a closely held corporation, the board of directors may be made up of only the corporation’s shareholders, which could conceivably be just one person. Regardless of how many people make up the shareholders and the board, it is imperative that every small business owner observe these requirements and hold these meetings at least once a year. And if there are only one or two shareholders or directors, the two meetings could be held at the same time.
An LLC should hold meetings of its members and/or managers to evidence that it is observing company formalities and is a bona fide business entity and not just a sole proprietorship or general partnership in disguise.
In addition, corporations and LLCs should hold meetings prior to making important business decisions such as purchasing large assets, establishing employee benefit plans, or taking out new loans. It is the absence of these meetings that can cause a court to determine that the entity doesn’t really exist; that its owners have been acting more like a sole proprietorship or general partnership and thus lead to piercing of the corporate veil. Also at the state level, not adhering to corporate formalities could cause the state to declare that the company is no longer in “good standing.” Being out of good standing for too long can lead to administrative dissolution which means that all of the benefits of being a corporation or LLC disappear.
Document Business Actions
Document corporate decisions and LLC actions by taking detailed notes during the meeting. These notes are referred to as the meeting minutes. They are an essential part of any meeting and are used as an official record of the decisions that were made during the meeting. That being said, it is not necessary to write down every detail or every word that was said during the meeting. Only important information needs to be included in bullet point format or brief summary paragraphs. The meeting minutes should include the date, time and place of the meeting as well as the names of the people who attended.
If your business ever becomes the subject of a tax audit, you may find that you have to prove that your company has a legitimate profit motive, particularly if you have suffered a few years of losses in a row. Having a record of annual meetings and important business decisions can help to demonstrate that your corporation or LLC was formed with a true business purpose in mind. In addition, if your company is ever involved in a lawsuit, having records of these items may help to defend against claims that you managed your company irresponsibly or even illegally.
Create and execute (sign) contracts for business activities involving personal assets – especially if you are a single owner entity – then be sure to keep copies of the documents. For example, if you intend to use your personal vehicle in your business, it is imperative that you have a signed lease agreement between yourself and your business outlining how much the lease payments will be, how they are to be paid and who is responsible for maintenance and insurance of the vehicle, among other things. The same holds true if you personally (or another entity you own) own the building that your company will be operating in. Again, having these signed documents can help support your case that you intended to run the business professionally and responsibly.
Use corporate resolutions to record the major decisions made by the company such as for the purchase of real property, approval of a long-term lease, or authorization of a large loan or line of credit. They are important because they indicate that the actions were taken by, and on behalf, of the company. All of this documentation should be kept in a Corporate Minutes Book – a separate binder for all records, resolutions and minutes of your entity.
Create Corporate Bylaws and LLC Operating Agreement
Corporate bylaws are the rules that govern the internal operations of a corporation and are probably the most important legal document of the entity. Bylaws typically set out the form, manner and procedures for how the company should be run and cover topics such as how, when and where meetings will be conducted, details about the board of directors, what officers the organization will have and a description of their duties.
For an LLC, the equivalent document is called the operating agreement. It is a document that provides a framework for how the entity will operate and covers topics such as percentages of ownership of the members, members’ rights, responsibilities and voting powers, and management details. A well written operating agreement can be indispensable in helping to settle any disputes that may arise among the parties.
Either document should be created as soon as you’ve formed your entity and customized for your company’s specific circumstances. Be sure to keep the document updated as policies, procedures or rules and regulations change. Make it a habit to review your bylaws or operating agreement at each annual meeting so that it reflects the most current understanding of the parties.
Helpful Resources
There are two really good manuals that I came across and often use as resources. They are “The Corporate Records Handbook” and “Your Limited Liability Company” by Anthony Mancuso. Both are available on Amazon.com and if you are interested in checking them out, I would appreciate your using the following links:
The Corporate Records Handbook
Your Limited Liability Company