Why Are Corporate Formalities Important?

Limited liability is a significant advantage provided by corporations and limited liability companies (LLCs). However, the personal asset protection that corporations and LLCs provide for their owners is not absolute. To maintain the liability shield, owners must comply with certain corporate formalities required by state law or recommended as a best practice. In addition, observing these important corporate formalities provides the accurate documentation and records needed for a business to operate successfully.

Limiting Personal Liability

Under some circumstances, the owners of a corporation or the members of an LLC can lose their limited liability protection and be held personally responsible for the obligations or debts of their business. This is known as “piercing the corporate veil.”

Without the liability shield that establishes corporations and LLCs as legal entities separate and distinct from their owners, many individuals would not engage in business because they fear being held personally responsible for a business’s actions, debts, and obligations.

LLCs are generally subject to fewer legal formalities than corporations. However, for both types of entities, following basic operating procedures such as holding meetings, keeping records, and establishing separate bank accounts helps maintain the liability shield. These formalities also help establish that a business is a separate legal entity from its owners, which precludes creditors from pursuing the owners to satisfy the business’s debts or obligations.

Maintaining Accurate Business Records

While maintaining a corporation’s or LLC’s separate entity status is arguably the most critical reason to observe corporate formalities, it is not the only reason. Corporate formalities also help create and maintain the body of information, data, knowledge, and experience that a company accumulates and needs to maintain for its future operations.

These records are a valuable business asset with numerous applications, including the following:

• Innovation and problem-solving: Corporate records can help organizations identify patterns and trends that could lead to developing new products, services, and business models. 
• Informed decision-making: Business documentation can be used to make informed decisions based on data and records.
• Improved collaboration: Good recordkeeping enables workers to share information and learn from each other. 
• Tracking progress and forecasting: Careful documentation helps track the long-term progress of prior plans and proposals and makes more reliable predictions and forecasts. 
• Business continuity: Corporate records document insider knowledge, promoting continuity of operations when there is employee and leadership turnover.
• Legal disputes: If a legal dispute arises between the business and an outside party or among owners, corporate records can provide critical evidence (e.g., what was said in a meeting or the specifics of a financial transaction).
• Tax matters: Detailed business records are indispensable for tax planning and payment.
• Proof of compliance: A business may need to demonstrate its compliance with legal obligations to various governmental bodies, including local licensing agencies, the state attorney general’s office, and the Internal Revenue Service.

How to Maintain Corporate Formalities

Corporations and LLCs are created by state law and must adhere to the rules established at the state level. The formalities required for corporations and LLCs are different, however.

Corporations

It is the responsibility of a corporation to observe the formalities required by the state(s) in which they operate. The following are some formalities that corporations typically must comply with:

• Establish and follow bylaws, which are a set of internal rules that govern how the corporation is run 
• Hold annual shareholder meetings at least once a year to elect directors 
• Hold board of director meetings—usually quarterly
• Keep meeting minutes, that is, an official record of who was at a corporate meeting, the topics discussed, and the decisions made
• Maintain stock ledger and stock certificates listing each individual shareholder’s name, address, and contact information to account for the total equity in the company
• Open a corporate bank account that is separate from the business owner’s bank accounts
• Register a business name,that is, a trade name or “doing business as” (DBA) name, that the business uses in addition to its corporate name 
• Maintain business records documenting all corporate activities, including notes from shareholding meetings, corporate tax filings, and corporate documents 

LLCs

Many corporate formalities are not required for LLCs but are considered best practices and are highly recommended.

For example, most states’ LLC statutes do not require LLCs to hold formal meetings or record minutes when meetings are held. LLCs are also not obligated to have a board of directors or, except for a handful of states, to create an operating agreement—the equivalent of corporate bylaws for an LLC.

Suppose an LLC does not have an operating agreement. In that case, it is subject to the default rules outlined in the Texas Business Organizations Code, which may not reflect the LLC members’ preferences about how to run the business. Failure to observe the following LLC best practices could threaten the liability shield and result in inadequate business records:

• Conducting business in the LLC’s name and not in the name of the individual members
• Maintaining a company bank account and not commingling personal and business funds
• Establishing a capital account for each LLC member that documents their initial investment in the company, their subsequent contributions, the distributions they receive, and their membership interest percentage
• Keeping accurate and detailed records of all financial transactions dating back at least three years, including paid bills, invoices, bank deposits, credit card statements, business contracts, income tax returns, and employee records
• Creating an operating agreement that establishes how the company should be run and outlines the duties and responsibilities of the members to each other and the business
• Holding regular meetings and taking minutes to document attendance, matters voted on and voting results, and topics of discussion

Your nEXT STEPS

A business attorney who understands the law and the risks that businesses face, internally and externally, can provide businesses with a professional, objective, top-level view of corporate formalities. We can help business owners observe the formalities necessary to protect themselves against personal liability for the business’s obligations and debts and maintain essential records for its operations—whether legally required or recommended best practices. Book a Free Discovery Call today.