Legal Matters | Archive

Observing formalities
Follow corporate procedures to keep your liability protection intact

by Dave Faulders
for Virginia Business
June 2007

Are you lax with your company's record keeping? Do you use company assets for personal uses? If so, you risk losing the important liability protection your company structure offers you.

People incorporate their businesses to limit their personal liability or for expected tax advantages. The personal liability protection granted by incorporating is practical and necessary. However, you must maintain proper corporate formalities to ensure you don't lose the limited liability protection and favorable tax treatment afforded by your corporate structure.

If a corporation is not managed formally, courts can't tell whether or not the corporation is actually its own entity - separate from its owner and its owner's assets. If it's not separate, a corporation won't be protected by limited liability and the owner's assets will be at risk in a lawsuit.

Also, the tax advantages expected to be achieved from incorporating could be threatened. In other words, in cases against corporations where corporate formalities are not strictly observed, whoever's doing the suing can "pierce the corporate veil" - break through that legal shield that protects the corporation's owners from extensive liability.

Keeping the corporate veil intact is relatively simple and straightforward - the key to piercing prevention is strict observance of all corporate formalities. You must observe essential formalities such as keeping minutes, holding regular shareholder and board meetings, maintaining books, issuing stock and adopting a charter and by-laws. Even if you run a small mom-and-pop shop that is incorporated, you should have a documented board of directors and hold regular meetings.

A corporation needs to be treated as a separate entity in order for the owners/shareholders to avoid potential liabilities and tax problems. Several important "arm's length" practices to keep the corporate veil intact include:

1. Maintain the existence of the corporation by filing annual reports with the State Corporation Commission.

2. Hold shareholder and director meetings pursuant to the bylaws.

3. Operate the corporation under the proper name or under a duly filed fictitious name.

4. Make sure that third parties who deal with the corporation are aware that it is a corporation.

5. Sign all contracts on behalf of a the company such as:
ACME, INC.

By: ______________________
Wile E. Coyote, President

6. Treat the corporation as a separate financial entity. The corporate checkbook should not be your individual checkbook - don't commingle corporate and personal funds. Payments to and from the corporation need to be properly documented as loans, capital contributions, compensation or dividend distributions.

7. Don't do transactions between the corporation and a director or shareholder other than on an "arm's length" basis (just as you would with someone not associated with the corporation).

8. Invoices for items purchased by the corporation should have the invoice show the corporation as the purchaser.

9. If the company owes money to a shareholder or related parties, document this with a promissory note, file a security interest lien or mortgage on corporate assets so that the individual will be paid before any third-party creditors.

10. Keep the company adequately capitalized for the company's operations.

Today, limited liability companies - or LLCs - are becoming more popular as an excellent legal entity for conducting business. They offer untold flexibility with respect to management and operation, excellent protection from liability and tax benefits in the form of their pass-through taxation.

Although the rules for observing the corporate formalities are not as stringent for an LLC as with a corporation, similar formalities should be taken in order for the LLC members to enjoy all of the limited liability and taxation benefits of the designation. A failure to maintain adequate records of acquisitions, business transactions and minutes of meetings, co-mingling of funds, lack of "arm's length" transactions with members and inadequate capitalization could lead a court to disregard the LLC entity and hold the members personally liable.

It doesn't matter the degree of pomp with which the formalities are carried out - the important thing is that you do it. Document your corporation or LLC thoroughly and on a consistent basis. It may seem silly now, but taking the extra time and energy to formalize the conduct of your corporation or LLC will keep your liability protection intact.