Consequences to Not Observing Corporate Formalities - Loss of Tax Deductions and Limited Liability
Businesses incorporate for two main reasons: tax benefits and limited liability. However, in order to get these benefits, the business has to act like a corporation - in other words, it has to observe all the formalities that allow it to be treated like a corporation. If you have not observed the necessary corporate formalities, the IRS can deny (on audit) all your corporate-specific tax deductions you thought you had. Likewise, if your business is sued, and the plaintiff's attorney reviewing your corporate records finds you have not observed corporate formalities, he can ask the court to "pierce the corporate veil" and hold you personally responsible for the lawsuit. It is imperative that all corporations observe the required formalities to avoid these potentially disastrous outcomes.
Corporate Formation - Complete ALL the Steps
The first formality is to complete the initial formation of your corporation; these do not end with filing the Articles of Incorporation and getting a Federal Tax ID Number. An initial Board Meeting must be held, and committed to writing, to complete the incorporation process, even if you are a one-person corporation. For example, director(s) and officer(s) need to to be formally appointed or elected, bylaws must be approved (and obeyed), the corporation must be capitalized, stock certificate(s) must be approved in form and physically issued, bank account(s) and signing authority must be established, state regulatory filings must be made, and employment contracts approved and signed, with all original documents and certified copies placed in the minute book. Consider this question from the IRS - "How could your business act as a corporation if there aren't even stockholders?"
Maintain Adequate Insurance Coverage and Limits
Corporations must maintain insurance coverage with adequate limits for their type of business. For most businesses, this means carrying general liability insurance (for the slip and fall accident and other business negligence issues), auto insurance (if your business involves any driving), malpractice insurance (for professionals like doctors and dentists), workers compensation insurance (for employee injuries), and product liability insurance (for those manufacturing or selling tangible products). There are many other types of insurance, and I recommend talking to a qualified commercial insurance agent to determine your appropriate coverages and limits - but please don't skimp on limits. A business that only carries $35,000 in auto insurance, but receives a $1 million claim would almost certainly be considered to not be carrying a adequate level of insurance, exposing it to losing its limited liability protection.
Don't Co-mingle Corporate Funds with Personal Funds
Next, corporations and their owners cannot co-mingle corporate and personal funds. This means that all corporate income must be deposited to corporate bank accounts, and only corporate/business expenses may be paid from corporate accounts. Likewise, personal income must be deposited and personal expenses must be paid from personal accounts. Corporate employees must be paid compensation through corporate accounts, with appropriate payroll tax withholding, payments and returns. (Loans back and forth are permitted, but must be formally authorized and documented - see below.) Co-mingling of funds ignores the requirement that the corporation and the owner be treated as separate entities, with separate income and expenses. Failing to observe this formality creates the potential loss of tax deductions and limited liability.
Complete Annual Corporate Minutes
If your corporation is audited by the IRS, the agent WILL demand your original minute book as part of the audit. All important corporate actions must be formally authorized by the corporation (although this requirement is suspended for "close corporations" which are not discussed here). For example, formal authorization is necessary for election of officers and directors, establishment and annual funding of retirement plans, buying medical insurance, issuing stock to new shareholders, changing banks and signing authority, and authorizing loans to and from the corporation (with a written note and an appropriate interest rate). Most items require just board approval, others require shareholder approval as well; and "interested party" transactions have a higher standard of approval. Formal authorizations can also be made via Unanimous Consent Form, and with that procedure no formal meeting need take place.
Submit Annual Corporate Filings
Finally, all states require that annual filings be made to keep the state apprised of the current directors, officers, addresses and service agent of the corporation. Professional corporations may have a separate annual filing to complete, identifying their professional employees and levels of malpractice insurance. Failing to complete these filings can lead to financial penalties and/or suspension of the corporation's charter. Suspension is the ultimate penalty - the corporation cannot enter into contracts, file lawsuits, defend itself in a lawsuit, or do any business whatsoever - by DEFINITION, it is no longer a corporation.
Rehabilitate your Existing Corporation
An existing corporation can complete missing formalities at any time to provide FUTURE protection (preferably through an experienced corporate attorney), but the corporation will remain exposed for the time period before those formalities are completed. Backdating corporate documents is fraudulent, so don't do it! The age of the paper, typefaces and ink used in your corporate documents can be established by scientific examination.
Forming and maintaining a corporation is the practice of law. While individuals are allowed to represent themselves (and frequently do), incorporation is a undertaking with important tax and liability ramifications. I highly recommend that every person forming a corporation do so (1) with the advise of a CPA and (2) through a qualified attorney, both of whom are experienced in corporate formation and maintenance, to avoid risking the loss of corporate tax benefits and limited liability.
Disclaimer - Legal Stuff
IMPORTANT: This Legal Guide is made available for educational purposes only. There is no attorney client privilege between you and the attorney author. This Legal Guide is not a substitute for competent legal advice from a licensed attorney that specializes in this area in your home state and with whom you have an attorney client relationship. Also, law changes frequently and varies from jurisdiction to jurisdiction. The information and materials provided are general in nature, and may not apply to a specific factual or legal circumstance described in the question. Copyright 2010 by Robert W. Olson, Jr. - all rights reserved.