Fatal Legal Mistakes Business Owners Make: Maintaining Corporate Formalities
This is the second in a 10-part series exploring legal mistakes that can be fatal to a business (even a seemingly well-established one). The illustrations and guidance provided are designed to help you spot these mistakes early. Each of these mistakes is preventable with proper planning and preparation.
Last month, I discussed the dangers of failing to set up a proper business entity. When properly incorporated and maintained, a corporation or a limited liability company can protect you from personal liability arising from owning and operating a business. The law recognizes a corporation or limited liability company as a separate “person” with separate finances, assets, and liabilities. Any company obligations remain at the company level, and the business owners’ personal assets are protected. So long as the business is properly maintained, Texas law makes it very difficult for a disgruntled customer, vendor, or employee to get at a business owner’s personal assets.
So, you’ve taken the first steps and properly incorporated your business. Congratulations! This article will discuss how to properly maintain that business so as not undermine the very reason you created it.
Read on for an illustration of how easily mistakes can arise, how fatal they can be for even the most successful business, and how to avoid them entirely with dedicated planning.
Mistake 2: Failing to Maintain Corporate Formalities
Business owners who make the effort to set up a formal business entity often fail to treat the company truly separate from their personal affairs. It’s often unintentional at first, but if you do not separate your business and personal interests, a court may find that you are personally liable for the obligations of the company despite the proper incorporation.
Carl was excited to begin his new auto mechanic business. He had read about the benefits of forming a corporation and, anxious to protect his personal assets, he submitted the appropriate paperwork for his company to the Secretary of State and received a federal EIN for filing separate business taxes. The business grew at a steady pace and was spinning off nice income for Carl.
When Carl met Jean and they got married, Jean kept up her real estate sales job and both she and Carl deposited some of their respective incomes into a joint account for paying household expenses and, eventually, paying tuition for their children’s private school. But while Carl’s business stayed strong, the real estate market slowed down considerably and Jean was no longer bringing in the commission checks she was used to.
When money in the joint account grew scarce every couple of months, it was nice to have Carl’s business there to pay the mortgage or the private school bill directly. And the deducted business expenses didn’t hurt the business’s tax returns. With the business thriving, Jean let her real estate license lapse and started working as the business manager for Carl’s business full time, also becoming a part owner.
Carl and Jean began using the business credit card for dinners out with friends, marking those charges as “business development” meals on the business’s ledger. Eventually, the business bought Jean a company car as well as Longhorn season tickets. And a few years later the business bought a small condo on the beach in Galveston for Carl and Jean to use with the kids on weekends in the summers. Carl and Jean were the only business owners, and the business revenue more than covered the business’s ongoing operating expenses, so who could it hurt?
As the business continued to grow, Carl and Jean spun off a related company. From time-to-time, that related company was a little short on funds, so Carl’s Racers, Inc., the stronger of the companies, would cover a payroll cycle for Carl’s Tires, Inc., or pay a Carl’s Tires’ vendor invoice directly. It was easy for Jean to transfer funds back and forth between the two entities using their online banking website.
But when a hurricane hit Texas, both businesses took a turn for the worse. One of Carl’s Racers’ biggest clients canceled its fleet maintenance contract when its trucks all got flooded; and Carl’s Tires had trouble fulfilling orders when two of its main vendors closed up shop in the aftermath of the storm. Carl and Jean cut expenses, but it wasn’t enough to keep current on both company’s bills.
Creditors began filing lawsuits against the companies and Carl and Jean had to hire attorneys. The attorneys for the creditors got copies of the businesses’ financial statements and bank records, and started poking and prodding at them, ultimately asserting that Carl’s Racers and Carl’s Tires were “alter egos” for Carl and Jean.
Jean got a call that her car was at risk of being sold to pay off the business creditors and the condo in Galveston had a lien filed against it, placing the mortgage in default. Carl and Jean were stunned when they learned that because they had not maintained proper corporate formalities, the court could disregard the corporate entities – “pierce the corporate veil” is how their attorney described it – and enter judgment against Carl and Jean personally.
How to Avoid Mistake 2
If you have gone to the effort to formalize your business through a corporation or limited liability company, be sure to treat the business like a real business. Keep business and personal finances separate. Open separate bank accounts for each entity and keep them separate from each other. Keeping finances separated means ensuring that the business only pays for business expenses out of its operating accounts.
If you as a business owner want to use some of your company’s extra cash to cover a personal expense, make sure the money is first paid out to you (be it through a dividend payment or a distribution) in accordance with your bylaws or company agreement. So long as the money is properly issued from the business to your personal account consistent with its operations, your use of the funds no longer implicates the business.
In addition to maintaining separate personal and business finances, you must also maintain other corporate formalities. You should hold regular meetings of the shareholders, officers, and directors – even if the business is only a “closely-held” company made up of family members – and properly record what’s discussed at those meetings. Update corporate minutes at every meeting and at least once each year.
Corporations should also file annual reports with the Texas Secretary of State as required and submit their franchise tax reports to the Comptroller, even if no tax is due. Corporations should also keep updated all contact information on file with the Secretary of State as needed, including the appointment of a registered agent (which will be discussed in detail in a future article).
Treating your business like a real business and maintaining proper corporate formalities will allow you to protect yourself from personal liability.
In the next article, I’ll address the fatal mistake of a business failing to segregate business funds and enterprises.