Tuesday, September 28, 2010

What are corporate formalities and why are they important to observe?

One of the main reasons why a business owner decides to incorporate is to limit his or her own personal liability for business debts. However, simply incorporating is not enough to enjoy protection of limited liability. One also needs to observe corporate formalities. Otherwise, the courts may decide to “pierce the corporate veil” of the business entity and hold the owner liable for the company debts. So, what does a business owner need to do to properly observe corporate formalities?

First, I want to point out that observing corporate formalities is important even for one-person corporations. Second, regardless of what anyone says, even LLC owners need to do it, not just owners of corporations (please keep reading, I’ll discuss LLCs a bit later).

Corporate formalities for corporations consist of the following (this may not be an all inclusive list, but I believe is a good start):

1. Bylaws. Every corporation must have bylaws, a set of internal rules governing how the corporation is run.

2. BOD Meetings. The board of directors of the corporation (needless to say that every corporation must have a board of directors, although these individuals can also serve as officers, subject to some exceptions) has to meet regularly. The secretary of the corporation should record minutes of the meetings, reflecting resolutions and discussions that the directors had at that meeting. The minutes would then need to be adopted by the board at the next meeting and put into a minutes book. All major decisions of the corporation should be adopted in a board resolution pursuant to the procedure set forth in the bylaws (such as mergers, stock issuances, major financial decisions such as loans, dividends, guarantees, hiring of consultants and legal or other experts, transactions with insiders, executive officer compensation, etc.).

3. Shareholders Meetings. Shareholders of the corporation should also have regular meetings (at least annually to elect directors), the secretary of the corporation should take minutes of the meeting and add them to the minutes book.

4. Stock Ledger. There needs to be a stock ledger reflecting the stock ownership of the corporation and the names and addresses of the shareholders.

5. Bank Account. The corporation has to have a separate bank account, and there should be no commingling of personal and business funds.

6. Business Name. All business of the corporation with third parties needs to be conducted in the name of the corporation so that it is clear that the directors and officers are acting on behalf of the corporation and not in their individual capacity.

7. Filings, Taxes. The corporation should file all appropriate federal, state and local tax returns and pay taxes when due, as well as obtain all necessary permits and licenses.

8. Assets. The corporation must have adequate capitalization and maintain proper operating capital.

9. Debt Guarantees. Shareholders should be careful not to personally guarantee and pay the debts of the corporation (at least not on the recurrent basis). Otherwise, the courts may decide that the owners act as alter egos of the corporation and the corporation has lost its separate entity status. Board resolutions should be adopted allowing guarantees for specified purposes only.

LLCs generally require less corporate formalities to preserve limited liability of their members. However, it is still important to do the following:

1. Have an operating agreement that defines member roles, outlines distribution guidelines and specifies operational and taxation rules.

2. Hold regular member meetings (some states like New York require at least annual meetings), adopt resolutions, record minutes, keep a minutes book.

3. Follow guidelines #4-9 above.

Following corporate formalities should become a part of doing business for both corporation and LLC owners. Board, shareholder or member meetings should take place on ongoing basis, and minutes of such meetings should be kept regularly. After all, it may be difficult if not impossible to recreate corporate formalities retroactively if the limited liability protection has been challenged.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

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