One of the requirements, when you form a corporation or LLC, is to operate the entity as a separate legal entity from yourself. Corporate formalities are the operating rules and guidelines a corporation must follow to be recognized as a separate legal entity. If corporate formalities are not followed, it is one of the areas where the corporate veil may be pierced, and the legal action will now point to the owners of the company.
Corporate formalities are not required for a sole proprietorship, because it is not a separate legal entity from yourself, and therefore, you have unlimited personal liability. When you form a corporation or LLC you have the advantage of a separate legal entity from your personal assets, but you must operate the entity as a such to maintain that layer of protection over time through formalities.
Below is a list of corporate formalities you will want to follow on an annual basis.
Corporate formalities fall into the following general categories:
- Corporate bylaws;
- Shareholder and director meetings (annual and special);
- Signing documents as a corporation;
- Corporate recordkeeping (financial and corporate documents);
- State annual filings (corporate report, franchise tax, federal and state corporate tax);
- Bank accounts (separate corporate bank accounts); and
- Financial statements (income and cash flow).
Creating and maintaining records is a huge part of following proper corporate formalities. The types of records you can be expected to keep for your corporation include the following:
- Accounting and bookkeeping records;
- Bank records;
- Contracts;
- Corporate records;
- Correspondence;
- Employee records;
- Business forms;
- Intellectual property records;
- Marketing and advertising records;
- Permits and licenses;
- Stock records; and
- Tax records.
Here are some of the finer points of the records and procedures that a corporation must follow:
Corporate Bylaws:
The corporation must adopt a set of bylaws which provide a written statement of how the internal affairs of the corporation will be handled. The bylaws set the time and place of regular shareholders and board of directors meetings. Changes to the Bylaws or Articles of Incorporation must be approved by BOTH the Shareholders and Directors. Amendments to the Articles of Incorporation must then be filed with the Secretary of State in the state of incorporation for the amendments to become effective. Some states also require corporations to file a notarized affidavit, which verifies the number of outstanding shares at the time of the vote.
Corporate Minute Book:
The corporate minute book contains a required written record of actions by the shareholders and directors of the corporation is a big part of your corporate formalities requirements. At a minimum, there must be annual minutes reflecting the election of directors by the shareholders. Any significant corporate activities, including corporate borrowings, purchases, and the payment of compensation to officers, should be properly reflected in the minutes of the meetings of the directors and shareholders. As a general rule, all records, resolutions and minutes of your corporation should be kept in the Corporate Minute Book for a period of no less than six years. This is a good idea because sometimes a Shareholder will want to inspect the corporate books and records to ensure the corporation is being run in its best interests. It’s probably wise to retain these records for a longer period, should anyone ever challenge the actions of the Board of Directors. (See section below, ” More On Corporate Minutes,” for further explanation on keeping proper minutes.)
Stock Ledger Book:
The corporation must maintain an accurate stock ledger book. This book shows who has been issued stock certificates and the amounts received by the corporation for the issuance of its stock. The stock ledger book contains an up-to-date record of the names and number of shares owned by each shareholder.
Conducting Business in Corporate Name:
When doing business with third parties, the officers and directors must make it clear that they are acting on behalf of the corporation and not in their individual capacity. Correspondence should be sent out under the proper corporate letterhead, and contracts should be entered into only with the corporation as a signatory. Unless the documents clearly reflect that a transaction is entered into on behalf of the corporation, and all necessary agreements are entered into under the corporation’s name, the corporate entity will not survive a challenge in a lawsuit.
Bank Accounts:
Corporate bank accounts and accounting records must be separate and distinct from the individual. A corporate bank account cannot be treated as if it were the account of an individual officer or director. Corporate income and assets must be separately accounted for on the corporation’s books. One of the biggest mistakes made by clients is that they feel free to move money and property back and forth between themselves and their corporation without properly accounting for such movement in the corporation’s records. This is a fatal mistake and, under these circumstances, the corporate entity will be disregarded by the court.
Corporate Resolutions:
Corporate Resolutions record the major decisions made by the corporation’s Shareholders or Board of Directors during meetings. While not always required, it’s a good idea to record your actions in the form of Corporate Resolutions, because Resolutions show third parties that the actions were taken by and on behalf of the corporation. Some Corporate Resolutions may be passed only by the Shareholders, others only by the Board of Directors, and some must be passed by both groups.
Bankruptcy or Dissolution:
Shareholders must also vote to dissolve the corporation or to file for bankruptcy or reorganization.
Everyday Corporate Operations:
Resolutions adopted by the Board of Directors that generally do not require Shareholder approval involve everyday operations of the corporation, including leasing, purchases, hiring, banking, borrowing, investing, paying of dividends, salaries, and bonuses, providing benefits for employees and changing the corporate status, such as obtaining “S-Corporation” status.
The Corporate Structure:
The structure of a corporation is made up of the Corporate Officers, the Board of Directors, and the Shareholders. Each plays a role in following corporate formalities, and, as such, must be aware of the responsibilities and parameters.
Corporate Officers:
Each corporate officer carries its own area of responsibility. Typically, the authority and responsibilities of each officer is described in the corporate bylaws and may be further defined by an employment contract or job description. The main officers are:
- President – Has the overall executive responsibility for the management of the corporation and is directly responsible for carrying out the orders of the Board of Directors. He or she is usually elected by the Board of Directors. The Actual fiscal policy of the corporation may rest with the Board of Directors and be largely controlled by the President on a day-to-day basis.
- Treasurer – The Chief Financial Officer of the corporation and is responsible for controlling and recording its finances and maintaining corporate bank accounts.
- Secretary (or clerk) – Typically responsible for maintaining the corporate records.
Most jurisdictions allow the same person to act in all capacities, provided he or she fulfills all responsibilities of each position. For example, the President is typically responsible for entering into contracts on behalf of the corporation; the Treasurer is responsible for maintaining and accounting for corporate funds, and the Secretary is responsible for observing corporate formalities and maintaining corporate records. These three positions are required in every corporation.
In addition to these required officer positions, a corporation may also have Vice Presidents and/or Assistant Secretaries or Assistant Treasurers.
The Board of Directors: The Board of Directors is essentially the management body for the corporation. The Board is responsible for establishing all business policies and approving major contracts and undertakings. In addition, the Board may also elect the President. Ordinary business practices of the corporation are carried out by the Officers and employees under the directives and supervision of the Board of Directors.
The Directors must act collectively for their votes and decisions to be valid, which is why Directors may only act at a Board of Directors meeting. This, however, requires certain formalities. One such formality is that the Directors must all be notified of a forthcoming meeting in a prescribed manner, although this can be waived or provided for in the corporation’s Articles of Incorporation or Bylaws.
For a Directors’ meeting to be valid, there must also be a “Quorum of Directors” present. A Quorum is usually a majority of the Directors then serving on the Board; however, the Bylaws may specify another minimum number or percentage.
The Board of Directors must meet on a regular basis (monthly or quarterly), but never less than annually. These are the regular Board meetings. The Board may also call special meetings for matters that may arise between regular meetings. In addition, Boards may call special Shareholders’ meetings by adopting a resolution stating where and when the meeting is to be held, and what business is to be transacted.
The first meeting of the Board of Directors is extremely important, because in that meeting the Bylaws, the Corporate Seal, Stock Certificates and Record Books are adopted.
Board members, like Officers, have a fiduciary duty to act in the best interests of the corporation and cannot put their own interests ahead of that of the corporation. The Board must also act prudently and must never negligently manage the affairs of the corporation. Finally, the Board must make certain that it properly exercises its authority in managing the corporation and does not abrogate its responsibilities to others.
This means that the board must be very careful to document that each Board action was reasonable, lawful, and in the best interests of the corporation. This is particularly true with matters involving compensation, dividends and dealings involving Officers, Directors and Stockholders. The record or Corporate Minutes of the meeting must include the arguments or statements to support the Board’s action and must detail why the action was proper.
Shareholders:
Because Shareholders are the owners of the corporation, the corporation’s Officers and Directors must ultimately serve the interests of the Shareholders. While a Shareholder’s role is not typically managerial, Shareholders are not powerless concerning the affairs of their corporation. The rights of the Shareholders are governed by the Bylaws of the corporation, as well as by prevailing state laws.
Generally, the shareholders vote on the following matters: (NOTE: laws may vary by state)
1. Appointment of the President;
2. Election of the Board of Directors;
3. Major changes in the basic organization of the corporation.
This last matter, also referred to as “Fundamental Corporate Changes,” may include the following:
- Change of name or address of the corporation;
- Change in the nature of the business;
- Change in bylaws;
- Change in type and number of shares of stock issued;
- Change in size or composition of the Board of Directors;
- Encumbering corporate assets;
- Dissolution or winding down of the corporation;
- Selling, consolidating or merging the corporation.
Shareholders, like Directors, cannot act unilaterally. They must act either at a regular Shareholders’ Meeting (ordinarily held annually after the end of the fiscal year) or at a Special Meeting of the Shareholders (ordinarily called at the request of the Board of Directors).
There must be notice of the meeting and notice of the agenda (items to be discussed and voted upon). Most states require at least 10, but not more than 50- or 60-days’ notice be provided. The Articles of Incorporation can specify a time period. Waivers of notice are allowed if the Board fails to notify Shareholders of the meeting, or an emergency prevents adequate notice.
Shareholders may typically vote in person or “vote by proxy,” that is, have another person vote in the stockholder’s place. It is important to remember that Shareholders vote their shares; i.e., it is the number of shares, not the number of Shareholders, that decide a vote. For example, if Shareholder A holds 500 shares and Shareholder B holds only 100 shares, there will be a total of two Shareholders present with a total of 600 shares represented. Obviously, Shareholder A has much more voting power than does Shareholder B.
As with Directors, there must also be a complete and accurate record (Minutes) of a Shareholders’ Meeting.
Some states allow certain actions (e.g., amending the Articles of Incorporation) to be taken without holding a shareholders’ meeting if 1) the corporation obtains a written consent to the action from ALL the Shareholders, AND 2) the written consent states what action the Shareholders have consented to. (Check with your state to find out how many Shareholders must sign a consent for it to be valid.)
Occasionally, there will be a combined meeting of Shareholders and Directors. This is perfectly permissible; however, Corporate Minutes must still be completed for each of the meetings.
| More on Corporate Minutes: |
During an audit, the IRS scrutinizes corporate minutes for discrepancies between the corporate resolutions adopted by the Shareholders and Board of Directors, and the actions of the corporation. The corporation can lose tax deductions and benefits if it does not conduct meetings that adopt resolutions supporting the actions taken by the corporation. Most importantly, the corporation’s status as a “separate legal entity” can be discredited.
Without an accurate corporate minute book, the IRS, the courts, and other taxing authorities may allow creditors, plaintiffs, and other entities to sue you personally for debts and actions of the corporation. Corporate Minutes provide a written record of important corporate transactions, including:
- Key legal, tax, and financial decisions
- Approval of bonuses or fringe benefits
- Contributions to retirement plans
- Rent payments
- Reasonable compensation
- Accumulated earnings
The Proper Procedure for Keeping Corporate Minutes:
If procedures are properly followed, the corporation should have no trouble keeping an accurate, easily referenced record of all meetings. These steps are a basic outline for any type of meeting:
- Specify the type of meeting (Directors’ Meeting, Stockholders’ Meeting, Special Meeting of the Directors, etc.)
- State the time, date, and location of the meeting.
- Record the full names and any titles of all those present.
- If anyone (or everyone) appears without receiving proper notice and waives notice, a common practice, record this fact.
- Identify, by name and title, the person who is conducting the meeting.
- State that an agenda was distributed and attach a copy of the agenda to the Minutes.
- Record the highpoints of discussion on each agenda item, including any motions, the seconding of any motions, the results of any voting, any dissension or abstentions, and anything else that does not seem trivial. If in doubt, include it in the Minutes.
- Attach to the Minutes copies of any resolutions passed, any documents offered as an addition to the Minutes, and any written reports discussed or referred to during the meeting.
- When the complete record of the meeting has been made, the secretary must sign the record as being the official Minutes of the meeting.
Forming a corporation or LLC online is more involved than just filing the articles and obtaining an EIN. In order to maintain the ongoing legal protection of your separate legal entity, you must maintain your corporate formalities (and LLC). A failure to do so could lead to piercing the veil of their corporation or LLC, putting your personal savings, equity not protected in your home by a homestead, and other personal assets at risk.
