So You Created a Legal Entity, What Now?
When you start your small business, the owner usually creates a separate entity to operate the business in the form of a corporation or limited liability company (LLC).
One of the principal reasons businesses create a separate legal entity is to shield the personal assets of the owners from the debts of the legal entity and to limit the shareholders' or LLC members' liability from claims against the entity. This limited liability is a function of the entity's status under state business statutes as a distinct legal entity, separate and independent of its owners. A corollary of the entity's status as a separate and distinct legal entity is the requirement that its shareholders or LLC members observe the legal requirements appropriate to its status. Where the shareholders or LLC members themselves disregard the entity's independent status, they place themselves at risk of having a court ignore the separate legal entity and impose personal liability on the individual shareholders or LLC members.
To help maintain the separate legal entity, the small business owner must ensure that its business is in fact operated as a distinct legal entity and that it properly adheres to all the corporate formalities to maintain the protection of the corporate form. Presented below are some of the common pitfalls of the small business owner and what you need to do to avoid them.
Creation of Company Records
Whether your company is a corporation or a LLC, it is important to observe all of the required formalities so that your company has its own distinct record of operation as a separate legal entity. A company that is run informally is a corporation or LLC in name only. Unfortunately, this failure becomes apparent only when a problem arises, such as a challenge to the legality of a corporate action, and at that point the resolution may carry a heavy cost. It is important to begin filling out the corporate book as soon as the corporation or LLC is formed and to document important corporate decisions with proper minutes.
In Wisconsin you must file with the Department of Financial Institutions (DFI) to legally operate a business within the state as a corporation or a LLC. Chapter 180 of the Wisconsin State Statutes applies to corporations and Chapter 183 applies to limited liability companies. These statutes require the person creating the entity to file an annual report with the DFI to maintain the entity's active status. Failure to file the annual reports will result in the administrative dissolution of your business entity.
Issue Shares to the Shareholders of the Corporation or Members Contribution Percentage in an LLC.
Although this point appears obvious, it is not at all uncommon that small privately held businesses neglect to issue shares to the owners of the corporation or record the contribution percentage of LLC members, with the result that needless disputes develop as to who the owners of the corporation or LLC are when disputes between the principals arise. Accordingly, it is important to issue share certificates to the shareholders, to record the names of the shareholders in the company's share register, and to document the corporation's receipt of payment for the shares. For an LLC, it is important to record the contribution of each member and their percentage ownership in the LLC their contribution creates.
It is equally important to have a buy sell agreement in place between the shareholders or LLC members in the event of the death or incapacity of a shareholder or LLC member. You do not want to create a situation where the ownership of any shares or LLC membership is in dispute once a shareholder or LLC member is longer able to make his or her own decisions.
Open a Separate Bank Account for the Corporation or LLC.
As a distinct legal entity, it is crucial to open a separate bank account in the name of the corporation or LLC and to keep meticulous records of all transactions. All corporate funds received by the corporation or LLC should be deposited in the corporate account. Under no circumstances should the funds of the corporation or LLC be commingled with personal funds of the owners or any other corporate entities. This is one of the main factors the courts look to in determining whether to disregard the corporate form.
Hold Regular Board of Director, Member and Shareholder Meetings.
Chapter 180 of the Wisconsin State Statutes entitled Wisconsin Business Corporation Law requires at least an annual shareholders' meeting. This meeting should always be held to maintain the entity's corporate identity. Chapter 183 applies to Limited Liability Companies. While the chapter does not require annual meetings, it is strongly suggested that the LLC members hold an annual meeting to maintain the entity's status as a separate legal entity. The Board of Directors of a corporation or LLC members should also hold periodic meetings as well. Minutes of all Shareholder, Member or Director meetings must be recorded and placed in the company's minute book. This attention to detail will help strengthen the independent status of the legal entity.
Document All Loans Between the Shareholders, Members or Employees and the Company.
If the shareholders, members or employees make loans to the corporation, or if the corporation makes loans to the shareholders, members or employees, make sure that these loans are properly documented on the books and records of the corporation or LLC, such loans are approved by the directors or members and reflected in the board minutes or member minutes and the loan is evidenced by a promissory note that provides for regular payments with interest. In the absence of a promissory note, a shareholder or member loan may be deemed a contribution to equity, which, in the event of dissolution, may not be repaid until all other creditors are paid in full.
Conversely, loans to shareholders or members that are not properly documented will create the appearance that the shareholder or member is disregarding the corporate entity and treating corporate accounts as his or her personal accounts. Such informal, undocumented loans ignore the existence of the corporation or LLC as a distinct legal entity, and may cause a court to ignore the corporate entity as well.
Pay All Wage Claims, Withholding and Sales Taxes.
It is crucial that the corporation or LLC pays all withholding and social security taxes and sales taxes. It is important that the corporation or LLC hire a competent and trustworthy controller or CFO, or at a minimum, a competent payroll company or accounting firm. In addition, it is highly recommended that the company engage the services of a separate audit company to audit the company's financial records periodically. If the company engages an outside accounting firm to keep the company's financial records and file its tax returns, that company should not perform any audit function. The audit function must be handled by a separate company to ensure independent results and checks and balances concerning the company's finances.
Always Sign the Corporation's Legal Documents in Your Corporate Capacity.
All legal agreements entered into by the corporation or LLC should be signed by the corporation or LLC by an authorized corporate officer, member or manager with his/her corporate title clearly indicated next to his/her name. Contracts entered into by the corporation or LLC should be clear that it is an obligation of the corporation or LLC, and should never be signed without the officer's corporate title prominently shown, so that it cannot be determined to be a personal obligation or guarantee.
By following through on all of the required record keeping and by treating the company as a truly separate entity in its business dealings, you can help to strengthen the status of the company as a separate legal entity and further protect the assets of the company's shareholders or LLC members.