Owners conducting business through a legal entity often do so to limit personal liability and to protect assets unrelated to the business from commercial risks. However, once formed, owners sometimes jeopardize those exposure limiting objectives by filing away their incorporation documents and neglecting corporate formalities. That approach may work fine until, of course, an adverse party argues that the business entity should be disregarded as an ‘alter ego’ of the owners.
To avoid this from becoming an issue, owners of business entities should be proactive in maintaining corporate formalities long before a lawsuit is ever filed. This blog briefly addresses some key formalities that corporate stakeholders should observe now to make it less likely for a third party claimant to successfully disregard the corporate form and reach personal assets to satisfy claims.
Because a legal entity exists separately from its shareholders, partners or members, the business owners should be careful to operate that way. As a practical matter, this means title to business assets should be in the corporate name and not in the name of the owners or related parties. Business licenses or permits, to the extent legally permissible, should also be in the name of the entity. If any owner or related party owns business assets, then the parties should document the arrangement via lease or other appropriate agreement.
In addition, owners must not commingle personal and business funds. The company should have bank accounts in the name of the legal entity. Business expenses should be paid out of a corporate account; likewise, customers or clients should submit their payments to a corporate account.
Furthermore, company agreements should be in the name of the business entity and executed by an authorized signatory on behalf of the entity. While certain significant business counterparties — for example, a lender, landlord, major supplier or equipment vendor — may demand a personal guaranty of corporate obligations from a creditworthy individual or entity, those arrangements should carefully differentiate the business entity obligor and the guarantor.
Finally, as a general matter, a corporate entity should have a properly constituted board of directors, duly appointed corporate officers and adequate books and records of board and shareholder meetings and actions. The specifics vary depending on the type of business entity.
For businesses organized as a corporation, California law mandates the minimum number of directors for a corporation in relation to the number of shareholders. A corporation must have at least three directors unless there are fewer than three shareholders. If there are fewer than three shareholders, the minimum number of directors may be equal to or greater than the number of shareholders (and the shareholder(s) may also act as director(s)). Accordingly, a corporation with only one shareholder must have at least one director; a corporation with two shareholders must have at least two directors.
Corporate officers vary by company and are typically defined in the bylaws. As a general matter, each corporation should at least have a president or chief executive, a treasurer or chief financial officer and a corporate secretary. The bylaws also often empower the board of directors to create and define additional officer positions by resolution.
The bylaws of a corporation will typically require shareholder and board of director meetings on at least an annual basis. Generally, these meetings can be convened in person or by telephone conference or, if all participants agree, by means of a unanimous written consent. In all cases, minutes or written consents should clearly document the matters considered and decided by the shareholders or directors. The operating agreement for a limited liability company will often have similar requirements and procedures.
Matters generally brought before an annual meeting of shareholders include the election of directors and presentation of an annual report regarding the corporation’s operations and financial condition. Other issues that typically require shareholder approval — whether at an annual or special meeting — include, among others, (i) approval of transactions between the entity and a corporate director or officer (including indemnification agreements, loans or corporate guarantees of personal obligations), (ii) amendments to corporate bylaws or articles of incorporation and (iii) material corporate transactions (such as a sale or merger involving the corporation or a substantial portion of its assets).
Issues typically considered by the board of directors at an annual meeting include the election of corporate officers and the adoption of corporate policies. Other matters generally approved by the board — whether at an annual or special meeting — include, among others, (i) the issuance of corporate securities, (ii) the declaration of dividends and other shareholder distributions and (iii) the approval of material corporate transactions (including business acquisitions or sales and corporate borrowings). It is also good practice to have the board of directors approve compensation and bonuses of executive officers.
When a business entity does not observe corporate formalities — such as commingling business and personal assets or failing to document approvals for entity actions — such actions or omissions may be considered as a factor in determining whether the corporate entity should be disregarded. An ounce of prevention is worth a pound of cure, as they say. Do not wait to start thinking about entity formalities until after an employee or other third party challenges the corporate form of your business in a lawsuit seeking to hold shareholders personally liable for company obligations.
Contact Eddy Carvajal or an attorney on the AALRR business and tax team to review your business entity practices and to assist you with preparing and maintaining adequate corporate records for your business.
This AALRR post is intended for informational purposes only and should not be relied upon in reaching a conclusion in a particular area of law. Applicability of the legal principles discussed may differ substantially in individual situations. Receipt of this or any other AALRR publication does not create an attorney-client relationship. The Firm is not responsible for inadvertent errors that may occur in the publishing process.
© 2020 Atkinson, Andelson, Loya, Ruud & Romo
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