Forming a Corporation: What are “Corporate Formalities” and Why are They Important?

Posted about 1 year ago. Applies to California, 1 helpful vote

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There are many considerations a business owner must think through before deciding which business entity to select. While a business owner may elect to do business as a sole proprietorship or as a partnership, he may inadvertently put his personal assets at risk by not implementing a structure that separates the individuals involved from the business itself. A corporation is one business entity option that limits the business owners’ risk of loss to the amount of money invested in the business, provided that the corporation adheres to basic “corporate formalities".

If corporate formalities are not followed, the corporation will not be recognized as a corporation and both business owners and shareholders may open themselves p to personal liability. When a corporation is found to have not followed corporate formalities, this is known as “piercing the corporate veil", which opens up a shareholder’s personal assets.

WHAT DOES IT MEAN TO ADHERE TO CORPORATE FORMALITIES

Adherence to corporate formalities is often cited as a significant disadvantage for those who consider a Corporation as a business form and this is often why many instead opt for a Limited Liability Company (LLC). In addition to entity maintenance and formalities, selecting the appropriate entity should also reflect tax, partnership structuring, and decision-making considerations, which is why individuals starting a new business should always seek qualified legal counsel and tax advice.

The following are basics of corporate formalities which must be followed. Keep in mind that each state has its own corporation laws, and in addition to corporate formalities may require different forms or documents to be filed on a regular basis.

Bylaws.

Bylaws are a set of internal rules which governs how the corporation is run. Every corporation must have bylaws which should be tailored to suit the needs of the corporation. Templates may be helpful as a starting point, but ultimately, each set of procedures set forth therein should be reviewed and revised as necessary.

Shareholders Meetings.

After a corporation is formed, a shareholders meeting should be held immediately and a board of directors elected. Thereafter, Shareholders of the corporation should meet at least annually to elect directors. A secretary should be appointed and minutes recorded at this meeting. Note that shareholders, board members and officers can be the same people and each can have multiple roles. In situations where a corporation is only owned by one person, the person will hold a meeting by himself and document the appointment of himself to the various roles.

Board of Director Meetings.

After a corporation is formed, the Board of Directors must hold an initial board meeting where the bylaws are adopted. A Secretary should be designated at the first meeting who will record the minutes of the meeting, which should reflect the discussions on meeting matters and resulting votes and resolutions. Board resolutions should reflect all major decisions of the corporation pursuant to the procedure set forth in the bylaws (such as mergers, stock issuances, major financial decisions such as loans, dividends, guarantees, hiring of consultants and legal experts, transactions with insiders, senior officer compensation, etc.).

Stock Ledger & Stock Certificates.

A stock ledger should be maintained reflecting the stock ownership of the corporation and the names and addresses of all shareholders. Stock certificates to represent ownership in the corporation should also be issued to those listed on the stock ledger. A stock ledger and certificates can be purchased online or at a stationery store.

Corporate Bank Account.

The Corporation must have a separate bank account in the name of the Corporation. You will need to authorize individuals within the Corporation to sign on behalf of the Corporation. Some Corporations will require two individuals to sign checks or authorize transactions over a predetermined amount.

ADDITIONAL CONSIDERATIONS

The following are additional considerations to establish strong corporate governance and to avoid any potential “piercing the corporate veil" problems.

All contracts entered into by the corporation should be in the name of the corporation so that it is clear that the directors and officers are acting on behalf of the corporation and not in their individual capacity.

The corporation should obtain a Federal Tax ID Number (FEIN) and file all appropriate federal, state and local tax returns and pay taxes when due, as well as obtain all necessary permits and licenses.

The corporation should retain a qualified accountant who can set up your books and records and assist you with your tax return.

The corporation should be adequately capitalized by maintaining adequate capital in the corporate bank account to meet all current and foreseeable debts.

The corporation should maintain adequate liability or errors and omission insurance necessary for the type of business conducted.

Consult with a lawyer before personally guaranteeing any debts of the corporation and do not offer to personally pay corporate debts.

No comingling of corporate and personal funds by placing any corporate funds in personal accounts.

Do not use corporate assets for personal use unless the board of directors of the corporation explicitly authorizes such use.

The aforementioned is not an exhaustive list, and as mentioned previously, there may be state filing requirements which have not been covered in this article. While maintaining corporate formalities for a small company is not difficult, issues do arise and it is very important to establish a strong corporate governance structure as your company expands. As such, you should seek the counsel of an experienced attorney familiar with corporations and corporate formalities.

Contact IBV Advisory Group Inc. for a consultation if you are considering setting up a legal entity for your business. You can call us at 310.746.3837 or email us at evelyn@ibvadvisorygroup.com

Additional Resources

Why Corporate Formalities are Important

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Related Topics

Sole proprietorship small business

A sole proprietorship is a business owned and operated by one person in which there is no legal distinction between the business and owner.

Incorporating a small business

Incorporation is the act of forming a corporation, a separate legal entity whose rights and liabilities are distinct from its shareholders.

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