In our last blog series, we explored the advantages and disadvantages of many common types of business formations and found a trend among them: the most popular forms offered limited liability – that is, legal and financial liability that is limited to what is invested in or integral to the operation of the business.
This is an important, oftentimes paramount benefit. However, it is a qualified benefit, meaning it can be taken away (or “disregarded” or “pierced,” in legal terms). The most important step for a business to take to maintain its limited liability status is to comply with formalities requirements set forth by state legislation. These formalities establish ground rules for a company’s operations and record-keeping, and the rules themselves depend on the type of legal entity your business takes on. (They also differ among states, though the similarities are many and the differences are usually minor and nuanced. For purposes of this blog, I will be discussing formalities requirements as they exist in a majority or totality of states, and will mention notable exceptions.)
LLC Formalities – The Baseline
LLCs, as we have seen, offer limited liability without the full breadth of corresponding corporate formalities requirements, so they will be our jumping-off point. Keep in mind that as we move on to discuss corporate formalities in the next section, they will build off of these baseline requirements.
Do Business in the Name of the Company. Business conducted with any and all third parties should be done in name of the LLC so that those third parties are put on notice and made aware that they are dealing with a limited liability company and not the company’s agents and representatives as individuals. This should include placing company letterhead on correspondence; identifying the name of the company on its website and other social media (including your chosen limited liability identifier); naming the company as a party in contracts and legal memoranda, and; making financial transactions through the company’s bank accounts.
Maintain a Company Bank Account. Set up and maintain capital accounts for your company. This should be done as soon as possible after filing your organizing documents and should be used for every company transaction from major purchase agreements to everyday office supplies. If a company agent must foot the bill for a purchase at any point, make sure there are clearly established rules for reimbursement (these are usually detailed in the operating agreement). Payments to the company on accounts receivable should never be made to personal accounts.
Don’t Commingle Personal and Business Funds. I’ll reiterate: payments to the company should never be made directly to personal accounts. Any dividends, salaries, or other monies owed to individuals within the company must go through the proper channels first. Further, company funds should never be used for personal purchases – this is the epitome of using the company as an individual’s “alter ego” and will go a long way in forfeiting your company’s limited liability status.
Maintain Adequate Capital Accounts. In so many words: fund your business. Make sure the company has adequate money to pay its debts and taxes, and continue operations. This is obviously a qualified requirement; if the company simply doesn’t have the money, that’s one thing – but business loans and positive cash flow should be properly allocated for continuing operations. As we’ve discussed in previous posts, directors owe a fiduciary duty to their company and its owners. Inadequate capitalization when those funds are available is a breach of the duty of care.
Where LLC Best Practices Meet Legal Requirements
Hold Annual Meetings. While this isn’t a requirement in most states, some states like New York do require annual meetings to be held according to the procedures set forth in the operating agreement. As a practical concern, annual meetings should be the bare minimum for connecting ownership and management to touch base.
Construct an Operating Agreement. Again, this isn’t a legal requirement except for a minority of jurisdictions. However, most banks will not permit you to open a business account with them unless you present a copy of your operating agreement. Additionally, if your company has multiple owners or you’re a single owner contemplating adding others in the future, an operating agreement is necessary as a practical concern – it is the contract you and the other owners and managers will use to keep each other accountable and keep the business on track.
Keep Sufficient and Accurate Organizational Records. Due diligence necessitates good bookkeeping. Organizational documents like the articles of organization and the operating agreement (if one exists) should be properly filed and maintained for inspection. If and when annual or special meetings occur, the meeting minutes should be kept, which detail attendance, votes and voting results, and important topics of conversation.
…And Financial Records. IRS audits can look back to the last three years of business – however, if fraud is suspected during the audit process, a government audit can reach back to day-one records. Best practice counsels maintaining all financial records, but at the very least keep your most recent three years on the books. Tax documents to maintain include: income tax returns, business bank account deposit slips and credit card statements, invoices, canceled checks, paid bills, employee identification and payment records, time slips/records of employment, W-4 forms, and copies of employment tax returns. It is also important (though not a legal requirement) to keep accurate copies of business contracts – or better yet, signed originals.
Corporate Formalities – The Full Scope of Formalities
At first blush, the LLC formalities list seems fairly robust; and depending on the scale of operations and the level of commitment to best practices beyond the legal low-water mark, it can be. The corporate equivalent of these formalities has a much higher legal standard for observance, however, particularly in the auditing process and the detail of recordkeeping. Add to that the potential breadth of administration in a public corporation versus a limited liability company, and the quantitative differences add up, even on a fundamentally similar checklist.
Additionally, corporations must observe the following:
Develop and Follow Articles of Incorporation and Bylaws. The articles and bylaws are the corporate equivalent of an LLC’s operating agreement. As we saw in the Entity Selection blog series, a corporation often has duties to those outside the management structure, so extra safeguards must be established. One of those safeguards is the legal requirement to adopt and maintain these organizational documents, which should explicitly lay out the company’s rules for operations. A well-crafted business plan – which should be best practice for your company – will pick up where the AOI and bylaws leave off, to cover things like long- and short-term goals, performance review procedures, budgeting, and tax planning.
Install a Board of Directors. Management headed up by a board of directors is mandatory for a corporation. These are the company’s elected leaders, having a fiduciary duty to execute the corporate bylaws to the best of their ability and judgment; a corporation simply cannot move forth without a serviceable board.
Hold Regular Board of Directors Meetings. As a central part of corporate governance, the board of directors should meet regularly to discuss, adopt, and assess major decisions within the company. Much of the high-level planning – from stock issuances and capital raising to hiring lower management and consulting – happens in the board room.
…And Shareholder Meetings. Likewise, shareholders of the corporation should also meet – once annually to elect directors, and additionally by special assembly when a “fundamental corporate change” needs to be discussed – things like mergers, dissolution, and amending the articles of incorporation or bylaws.
Keep Accurate and Thorough Records. Tax, financial, and organizational documents: these records must be kept up-to-date throughout the life of the corporation. Where some such records may be best practices for an LLC, they are an absolute requirement for a corporation; so refer to the “LLC Best Practices” section for a recap.
Draft and Maintain a Stock Ledger. Every corporation should keep and maintain a stock ledger which lists each individual shareholder’s name, address, and contact information, as well as total stock ownership. A stock ledger is an accounting of the total equity in a corporation, and should always be complete and up to date.
Thank you for your readership and continuing interest in Daniel Ross & Associates! Let’s continue the discussion in the comments.
All the best,