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The Importance of Corporate Formalities

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It is difficult to understate the importance of maintaining accurate and comprehensive corporate records. Consider the following scenario. An entrepreneur, Robert, decides to incorporate his business. He files Articles of Incorporation with the Secretary of State and obtains a tax identification number.

However, Robert's newly formed corporation never issues shares of stock, holds an annual meeting or attends to any other corporate formalities. Robert's business continues to grow, but when a contract dispute arises a creditor of Robert's corporation files a lawsuit. Are Robert's personal assets protected? Perhaps not.

Protecting the Corporate Shield
Although many business owners recognize the benefit of moving beyond a sole proprietorship model and form a corporation, limited liability company (LLC) or limited partnership (LP) to protect their personal assets, many neglect the corporate formalities that courts, the IRS and even other shareholders or partners will look to should problems with the business arise. In Robert's case, for example, the creditor may argue that it should be allowed to recover from Robert's personal assets because his corporation is really a sham and not operating as a truly separate entity. This type of argument is called "piercing the corporate veil."

The creditor in Robert's case may be successful in piercing the corporate veil if Robert cannot demonstrate that he treated the corporation as a separate legal entity. It may also be possible under the same "piercing the corporate veil" theory, for the IRS to recover unpaid corporate taxes, or for personal injury claimants to recover their damages from Robert's personal assets. If you, as a business owner, ignore the separate existence your corporation, it may be similarly disregarded by the courts, with the result being that you may be held personally liable for debts of the corporation.

As you can see, simply registering a company with the state and obtaining a tax identification number is insufficient. Instead, a business owner should do everything possible to bolster the corporate shield and demonstrate that the corporation has a separate existence from the individual owner(s). To ensure that proper corporate formalities are being observed, every corporation, LLC and LP should maintain the following corporate records:

Articles of Incorporation: When the company is incorporated, the articles of incorporation are the first basic document. The Articles are filed with the Secretary of State. The document is proof of the corporation's existence. It sets forth the corporate purposes and powers and authorizes the issuance stock.

Certificate of Incorporation: The Secretary of State issues the Certificate of Incorporation after signing it and declaring the corporation to be a legal entity.

Bylaws / Operating Agreement: Bylaws in the case of a corporation, and an Operating Agreements for LLCs and LPs, set forth the rules for internal governance of the company. What are the shareholders' voting rights? When is the annual meeting? Is the LLC managed by its members or will there be a Manger? How are new members admitted to the LLC? All these issues should be addressed in a well drafted Bylaws and Operating Agreements.

Stock Certificates and a Stock Ledger: Ownership interest in a corporation is evidenced by certificates of stock. Copies of the issued stock certificates should be kept and documented in a stock ledger. The ledger should provide information regarding the shareholder's name and address, the date of the share's issue, and documents with the shareholder's signature acknowledging receipt of the certificates.

Legal Documents: Corporations necessarily deal with a lot of legal documents including contracts such as leases and vendor/customer agreements, government related documents, franchise agreements and business related licenses. All these should be kept in a single binder.

Financial Records: Corporations must document all of their financial activities and maintain a current balance sheet that is separate from the owner's personal finances. Never pay a personal bill from a corporate account. Failure to maintain separate finances is the number one reason for piercing the corporate veil. The company must also keep detailed records of all its financial transactions, and to the greatest extent possible, make its regular payroll and dividend payments consistent. A good credit history will take time and effort to develop, but if you are diligent your company may develop its own purchasing power and obviate the need for you to personally guarantee business transactions. In the alternative, a record of separate finances may prevent you from having to file personal bankruptcy in the event your business not successful.

Meeting Minutes: All corporations are required to host annual meetings of the shareholders to elect a board of directors. LLCs and LPs are similarly required to hold annual meeting for their members and partners. The minutes of these meetings should identify the parties who were present and memorialize any action taken. Copies of the minutes, along with any resolutions that were adopted, should be kept in a single binder.

While it may seem overly cumbersome or even silly for a small company to maintain such formality, especially if it is owned by just one person, this is precisely the situation most vulnerable to piercing the corporate veil arguments. However, when the business is operated with appropriate corporate procedure, the owners can be confident that their corporate shield will remain unbroken.

Avoid or Resolve Conflict between Shareholders or Partners
Appropriate corporate documents can also help resolve or avoid conflicts between the shareholders of a corporation. Let's assume that Robert's business continues to grow and he decides to sell additional shares in the corporation to Charles, an investor. Charles makes his investment, the corporation issues shares in his name and notes the transaction in its stock ledger.

After a few years Charles passes away. The only document dealing with this scenario is a small notation in Charles's Will leaving all his interest in the corporation to his wife who has no interest in running the business. What happens to Charles's shares? Can Charles's wife sell the shares to a third-party? What right does she have to run the business? Can the corporation buy the shares? At what price? These questions and other important matters should be dealt with in a Shareholder's Agreement executed at the time the corporation is formed or new shares are sold.

A well drafted Shareholder's Agreement should define restrictions on the transfer of shares, methods for determining shareholder's salary, distribution of dividends and address any number of other matters that may be of specific concern to the parties involved. If Robert or Charles had executed a Shareholder's Agreement when Charles made his initial investment in the company, Robert and Charles's wife could have avoided many of the uncertainties they now face. Without such an agreement, however, the parties almost certainly face conflict, and perhaps even litigation that could forever change the nature of the business.

Comprehensive Corporate Records Increase the Value of Your Business

Complete and accurate corporate records are a sign of a well run business. Well run businesses are more likely to be successful and survive lean times. Suppose that after a prosperous career Robert decides to sell his stock in the corporation and retire. Potential buyers will want to thoroughly examine the corporate records. An accurate, fully documented record showing the history and growth of Robert's corporation will impress potential buyers and provide him with confidence to negotiate the best purchase price possible.

Steve Mills is the managing partner in the law firm of Mills & Hoopes, LLC, in Lawrenceville, Georgia. For more information on our legal services or your legal needs in areas such as contractual matters, litigation, commercial real estate, immigration, environmental matters, wills, divorce and family matters, personal injury, collections, small claims, landlord tenant or any criminal matters, please visit out website www.millshoopeslaw.com 

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