Limited liability is a legal principle that protects business owners and shareholders from being held personally responsible for the debts and liabilities of their companies. Without the liability shield that establishes corporations and LLCs as separate and distinct legal entities, many individuals would not take the risk of engaging in business. This personal asset protection, however, is not absolute.
To maintain the liability shield, owners must comply with certain corporate formalities required by state law or recommended as a best practice. In addition, observing these formalities provides the accurate documentation and records needed for a business to operate successfully.
Limiting Personal Liability
Under some circumstances, the owners of a corporation or the members of an LLC can lose their limited liability protection and be held personally responsible for the obligations or debts of their business. This occurs when a creditor is able to “pierce the corporate veil.”
A corporate veil is pierced—making individual owners personally liable—when a court determines that the business owners, directors, members, and/or shareholders did not create a separate and distinct legal entity.
This might occur If the business is used for fraudulent purposes, is undercapitalized, or if the owners commingled their personal assets with the business assets.
While LLCs are generally subject to fewer legal formalities than corporations, both types of entities should follow basic operating procedures to mitigate the chance of their corporate veil being pierced, formalities such as holding meetings, keeping records, and establishing separate bank accounts for the business. These formalities also help establish that a business is a distinct legal entity separate from its owners, which precludes creditors from pursuing the owners to satisfy the business’s debts or obligations.
Maintaining Accurate Business Records
While maintaining a corporation’s or LLC’s separate entity status is arguably the most important reason to observe corporate formalities, it is not the only reason. Corporate formalities also help create and maintain the body of information, data, knowledge, and experience that a company accumulates and needs to maintain for its future operations.
These records are a valuable business asset with numerous applications, including the following:
- Innovation and problem-solving: Corporate records can help organizations identify patterns and trends that could lead to the development of new products, services, and business models.
- Informed decision-making: Business documentation can be used to make informed decisions based on data and records.
- Improved collaboration: Good record keeping enables workers to share information and learn from each other.
- Tracking progress and forecasting: Careful documentation is useful for tracking the long-term progress of prior plans and proposals and making more reliable predictions and forecasts.
- Business continuity: Corporate records document insider knowledge, promoting continuity of operations when there is employee and leadership turnover.
- Legal disputes: If a legal dispute arises between the business and an outside party or among owners, corporate records can provide key evidence (e.g., what was said in a meeting or the specifics of a financial transaction).
- Tax matters: Detailed business records are indispensable for tax planning and payment.
- Proof of compliance: A business may need to demonstrate its compliance with legal obligations to various governmental bodies, including local licensing agencies, the state attorney general’s office, and the Internal Revenue Service.
How to Maintain Corporate Formalities
Corporations and LLCs are created by state law and must adhere to the rules established at the state level. The formalities required for corporations and LLCs are different, however.
Corporations
It is the responsibility of a corporation to observe the formalities required by the state(s) in which they operate. The following are some formalities with which corporations typically must comply:
- Establishing and following bylaws, which are a set of internal rules that govern how the corporation is run
- Holding annual shareholder meetings at least once a year to elect directors
- Holding board of director meetings—usually on a quarterly basis
- Keeping meeting minutes, that is, an official record of who was at a corporate meeting, the topics discussed, and the decisions made
- Maintaining stock ledger and stock certificateslisting each individual shareholder’s name, address, and contact information to account for the total equity in the company
- Opening a corporate bank account that is separate from the business owners’ bank accounts
- Registering a business name, that is, a trade name or “doing business as” (DBA) name, that the business uses in addition to its corporate name
- Maintaining business records documenting all corporate activities, including notes from shareholding meetings, corporate tax filings, and corporate documents
LLCs
Many corporate formalities are not required for LLCs but are considered best practices and are highly recommended.
For example, most states’ LLC statutes do not require LLCs to hold formal meetings or record minutes when meetings are held. LLCs are also not obligated to have a board of directors or, except for a handful of states, to create an operating agreement—the equivalent of corporate bylaws for an LLC.
If an LLC does not have an operating agreement, it is subject to the default rules set forth in the state’s LLC laws, which may not reflect the LLC members’ preferences about how to run the business. Failure to observe the following LLC best practices could threaten the liability shield and result in inadequate business records:
- Conducting business in the LLC’s name and not in the name of the individual members
- Maintaining a company bank account and not commingling personal and business funds
- Establishing a capital account for each LLC member that documents their initial investment in the company, their subsequent contributions, the distributions they receive, and their membership interest percentage
- Keeping accurate and detailed records of all financial transactions dating back at least three years, including paid bills, invoices, bank deposits, credit card statements, business contracts, income tax returns, and employee records
- Creating an operating agreement that establishes how the company should be run and outlines the duties and responsibilities of the members to each other and the business
- Holding regular meetings and taking minutes to document attendance, matters voted on and voting results, and topics of discussion
Call Us Today
A business attorney who understands the law and the risks that businesses face, internally and externally, can provide businesses with a professional, objective, top-level view of corporate formalities. We can help business owners (1) ensure they are observing the formalities necessary to protect themselves against personal liability and (2) maintain essential records needed for the business’s operations—whether legally required or recommended best practices. Call us today to set up an appointment (651) 738-3433.