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Operating Formalities

Corporate Formalities are formal actions that must be performed by a Corporation’s director, officers, or shareholders in order to maintain the protection afforded by the formation of the Corporation. These are essential procedures that serve to protect the personal assets of a Corporation’s directors, officers, and shareholders.
The Primary Formalities are:

  1. Corporate Funds must be maintained separate and apart from Personal Funds.

    The corporate entity should have it’s own banking accounts (to include checking, lines of credit, etc.). Not keeping these funds separate, also known as “co-mingling,” can lead to increased scrutiny and potentially serious liability in the event of audit by the IRS with the endangerment of personal assets. It is a best practices procedure not to co-mingle funds.

  2. Meetings of the Board of Directors’ must be held at least annually, usually following closely behind Shareholder meetings (also known as “Special Meetings”). All 50 states mandate a meeting being held at least once a year.

    These annual meetings should be used to approve transactions entered into by the Corporation.

    In lieu of attendance by any given Director, written consent must be provided by said Director (either in the form of a waiver in the absence of proper notice, or in the form of a proxy vote given proper notice) for any decisions made at these meetings.

    Meetings of the Shareholders, also known as “Special Meetings” can be held at any time.

    The Corporation’s Secretary is responsible for giving proper legal notice of these meetings, and for maintaining the necessary waivers, proxies, minutes, etc.

  3. Corporate Minutes, or “notes of the meetings of the Board of Director’s or Special Meetings” are essential and are the official, legal record of such meetings.

    The Corporate Minutes are to be maintained in date order in the Corporate Minute Book, and can be a valuable asset in the protection of the Corporation’s directors’, officers’ and shareholders’ assets. Proper, timely maintenance of these minutes is essential in defending against audits by IRS and alter ego claims.

    Directors and Corporate Officers will at times seek legal counsel during annual meetings, and any discussions during these sessions are considered privileged conversations and protected by the legal doctrine of Attorney-Client Privilege. However, minutes taken of these conversations are considered part of the Corporate record and hence care must be taken, by the Corporate Secretary, to note when these communications occur by citing them in the Corporate Minutes as “Conversations by the members of the board of directors and legal counsel engaged in legally-privileged conversation at this point” instead of noting the actual conversation verbatim.

  4. Written Agreements for all transactions should be executed and maintained.

    All transactions that involve real estate leases, loans (whether internal or external), employment agreements, benefit plans, etc. that are entered into by or on behalf of the Corporation must be in written agreement form.

    Improper or untimely documentation of internal loans from a Shareholder to the Corporation, for example, may lead to IRS re-classification of repayment of the principal on said loan as a dividend, with the commensurate tax liabilities incurred by the Shareholder

    It is imperative that executive compensation, capital asset acquisitions, etc. be timely and properly documented in these minutes. Failure t properly and timely documents these can potentially lead to tax liabilities on the part of the Directors, Officers, or Shareholders as a result of IRS “reclassification.” For example, the IRS may classify what they deem as “excessive, undocumented executive compensation” as a dividend by the corporation to the recipient, and hence not tax deductible by the corporation–this will lead to increased, unpaid tax liabilities.

We cannot stress highly enough that failure to observe and implement these formalities will serve to diminish and mitigate the protections offered by the formation of the Corporation and will allow outside entities (the IRS, creditors, claimants/plaintiffs, potential adverse litigants, etc.) to “pierce the corporate veil” and peer into the inner workings and assets of the Corporation, it’s Officers, Directors and Shareholders.


Corporate Operating Formalities

The essential rules of operation for a corporation are known as the “Corporate Formalities,” or “Operating Formalities.” These rules were designed to ensure that the separate legal entity status afforded a corporation is maintained, and the observance of the rules ensures that the all of the benefits commensurate with the formation of a corporation are not compromised. These formalities should be observed by all officers, members, and directors of a corporation, with specific duties and implementation assigned as appropriate. Failure to observe these formalities can lead to the “piercing of the corporate veil” by outside regulatory, tax, or other agencies.

  • The Corporation must maintain an accurate account of all meetings by the board or special meetings held by the shareholders. These accounts, or notes, are known as “minutes,” and are maintained in the corporate “minutes book.” The care and accuracy of the minutes is a direct responsibility of the corporate Secretary. It is important that thorough and accurate minutes are maintained by the Secretary, as these minutes can prove invaluable against attempts to disprove the separate legal entity status of the corporation by regulatory or other agencies.
  • There shall be no co-mingling of corporate funds. This means that private assets belonging to a director, officer, or shareholder of the corporation should not ever be “mixed” with the company or corporate funds. Co-mingling can occur via such simple acts as paying company invoices directly from a personal checking account, or conversely, paying a personal auto loan from the company check book. These types of actions serve to undermine the separate legal entity status of a corporation, and can lead to direct personal liability or the loss of personal assets in the event of litigation, tax, or collections proceedings.
  • The Corporate Board of Directors must meet at least once a year. These meetings are required by all 50 states, and are the formal meeting during which important strategic corporate decisions are undertaken, such as large acquisitions, mergers, strategic transactional or contractual agreements with other entities, etc. In addition, it is usually during these meetings that decisions regarding corporate leadership are made, and where officer positions are affirmed, changed, and even a chairman or CEO is appointed. Attendance is a must by all directors, unless written consent of assignment of proxy vote is granted to another member of the board by the absentee member.
  • All contractual agreements entered into by the corporation, at the corporate level, must be memorialized in writing, with express consent of the Board of Directors. This includes all financially-binding agreements (loans, lines of credit, etc.), acquisitions (real estate, other corporate entities, capital equipment, etc.), and employment (with officers, etc.). Failure to properly engage other entities or potential employees may result in severe tax or fiscal liabilities, and in extreme cases, may jeopardize the separate legal entity status of a corporation if there are implications that an officer or member of the Board was using the corporation or its assets as his alter-ego.

The implementation and structure of these formalities will of course vary with the type of corporation formed, but the basic, essential structure is the same. These formalities are an essential component of the corporate operation and should be adhered to as a matter of course. Failure to adhere to the corporate formalities will often lead to a weakening of the asset protection, and limited liability protection, afforded by the formation of a corporation, with the commensurate consequences.

Formal Corporate Structure

Corporate Officers

Corporate officers typically consist of the President, Vice president, treasurer and secretary. A corporation can choose to have more officer positions, but these are the standard, best practices positions. Many states allow one person to hold all of the offices, but this may not be the best practices approach. The authority and responsibilities of each officer are outlined in the corporate bylaws.

  • The President

    The President of the corporation is usually elected by the Board of Directors and is responsible for carrying out the orders issued by the Board of Directors. The President is the figure head of the corporation.

  • The Treasurer

    The Treasurer is responsible for the management of all corporate funds, bank accounts, lines of credit, and for recording all corporate financial transactions. While many of these duties are self-directed, the Treasurer takes his or her direction from the Board of Directors.

  • The Secretary

    The Secretary plays a vital role in that he or she is responsible for the upkeep and safeguarding of corporate records. This includes, but is not limited to, the formation documents, the corporate minutes, and any business transactions or written agreements entered into or on behalf of the corporation.

The Board of Directors

The Board of Directors is the governing body of the corporation that directs the fundamental policies and major undertakings of the corporation. The directors usually elect the president and leave general operations and day-to-day business to the president and other officers under their employ, but usually require consulting before any substantive decisions or agreements are entered into.

The Corporate Shareholders

Shareholders (also called stockholders) are the owners of a corporation. As such, the board of directors and the officers of the company owe a fiduciary duty to the shareholders to do what is in their best interest as a group. Specific shareholder rights are outlined in company bylaws and in state law, and these laws vary from state to state. Though specific duties and reporting practices vary from state to state, the shareholders generally vote on the president, the election of the board of directors and any major changes in the composition or organization of the corporation.

A shareholder or stockholder in a corporation can be an individual or another company or corporation that is considered an “owner” of the existing corporation because it legally owns at least one share in the stock of the corporation. Usually holding the right to one vote per share on matters such as elections to the board of directors, the right to share in distributions of the company’s income, the right to purchase new shares issued by the company, and the right to a company’s assets during a liquidation of the company, the person or persons who own a majority of the stock can generally vote in the board that best suits their interests and run the company. Another important point to note is that although directors and officers of a company are bound by fiduciary duties to act in the best interest of the shareholders, the shareholders themselves normally do not have such duties towards each other.

Corporate Officers

A Corporate Officer is a high ranking person in a given corporation that is assigned a title indicating his position within the corporation. While a corporation may have many positions under its purview, only the persons holding the highest ranking positions are considered “corporate officers” (or executives).

Most corporations include at least the following Officer or Executive positions:

  • Chief Executive Officer (CEO)
  • President
  • Secretary
  • Treasurer

Other common officer positions are:

  • Chief Financial Officer (CFO)
  • Chief Operating Officer (COO)
  • Chief Information Officer (CIO) and (Fractional CIO)
  • Chief Information Security Officer (CISO)
  • Chief Knowledge Officer (CKO)
  • Vice President
  • Director-General
  • Managing Director
  • Executive Director

Members of the Board of Directors can also be officers, but this is not mandatory nor necessarily so–the titles can be whatever the shareholders want them to be, though these must generally be outlined in the bylaws of the corporation. Further, many times positions can be combined with one person holding more than one title, and with various positions holding different reporting obligations (for example, in some cases, the President may be asked to report to the CEO, while in other organizations, the CEO may be asked to report to the President). Or they can even have multiple people holding the same title (which is often the case with the Vice President title).

Corporate Resolutions

Corporate resolutions are written resolutions that serve to outline strategy, compensation, and benefits to the shareholders and officers of a corporation. While they are not required for every corporate decision, it is a best practice procedure to record the major decisions of the corporation in the form of written resolutions. This strengthens the corporations legal shield by providing solid evidence that any actions were taken on behalf of the corporation and not on behalf of the owners or officers.

Corporate Bylaws

Corporate bylaws, or the “rules” for the corporation and it’s shareholders, are drafted by a corporation’s founders or directors under the authority of its Charter or Articles of Incorporation. Bylaws widely vary from organization to organization, but generally cover topics such as how directors are elected, how meetings of directors and shareholders are conducted, and what officers the organization will have and a description of their duties. They can generally be amended by an organization’s Board of Directors

We cannot stress highly enough that failure to observe and implement any of these formalities will serve to diminish and mitigate the protections offered by the formation of the Corporation and will allow outside entities (the IRS, creditors, claimants/plaintiffs, potential adverse litigants, etc.) to “pierce the corporate veil” and peer into the inner workings and assets of the Corporation, it’s Officers, Directors and Shareholders.


Limited Liability Company Operating Formalities

Limited Liability Companies are becoming more and more popular as an excellent company organizational vehicle for conducting business, with very good reason. They offer untoward flexibility with respect to management and operation, excellent protection from liability, and they offer profound taxation benefits in the form of their pass-through taxation. There almost seems to be a scramble by some states to lure corporations in general, and LLC’s in particular, to them in the form of very business-friendly acts and legislative moves. Even so, there are certain operational and organizational steps, sometimes known as “LLC formalities,” that must be taken and adhered to in order for the members to enjoy all of the limited liability and taxation benefits afforded the LLC.

Piercing the LLC Veil

“Piercing the corporate veil” is the equitable remedy courts use to disregard the corporate structure, and this can translate into a piercing of the “LLC veil.” If a corporation is found not to be operating in observance of the formalities, an owner is exercising excess control, funds are being grossly misappropriated for the benefit of an owner, or if the corporation is deemed to be operated in such a manner as to cause harm to another entity, the courts can pierce the corporate veil and make the owner(s) personally liable for any debts or obligations of the company. The same can be true, although admittedly to a lesser extent, of an LLC. If a member exercises excess control over the entity, if the member in control engages in improper conduct in the exercise of control over the entity; and this improper conduct causes another entity to be denied adequate remedy in a lawsuit or business transaction proceeding, some courts may “pierce the LLC veil” and make the members or managing member directly responsible for the debt or obligation.

Traditionally, courts have looked at numerous factors to determine whether a controlling member/shareholder engaged in improper conduct. Chief among these factors would be the lack of an operating agreement, or a poorly written one. Too, a failure to maintain adequate records of acquisitions, business transactions, and in some states, minutes of meetings could lead a court to disregard the entity and hold the controlling member personally liable.

While the rules for observing the corporate formalities are not as stringent for an LLC, there are obviously still some semblance of formalities that must be observed. Having a well-written operating agreement in place should be obvious by now, but there are a couple others. The important ones (but by no means the only formalities) are listed below.

LLC Formalities

  • Having a well written Operating Agreement in place, with well defined roles for members, well outlined distribution guidelines, and operational and taxation rules.
  • Adequate records for all transactions and business engagements, as well as properly written minutes of meetings (at least one state, Tennessee, requires an annual meeting of the members). List of members, past and present, articles of organization, tax returns for the past three years, bank statements, resolutions authorizing activities that, either by law or under the terms of the operating agreement, require a vote of the members, etc. Are all examples of the types of records and written agreements that should be properly maintained by the LLC
  • Adequate capitalization for the company and maintaining proper operating capital

These are but a few, though vital, suggestions of formalities that should be observed. Other actions, or lack thereof, that could lead to the piercing of the LLC veil include:

  • Actions not covered in the Operating Agreement of an LLC–this is tantamount to disregarding the LLC formalities. Although an LLC is technically not required to observe formalities in the same manner that a corporation is, its actions should be completely guided by the operating agreement, and this agreement is taken into consideration by the courts and tax authorities when a determination is made as to the operation of the LLC.
  • Deficient or inadequate capitalization is another important deficiency that a court or tax regulator will examine when determining the intent of the LLC and its member’s and will usually factor heavily in their decision to pierce the veil. It is important that an LLC be properly capitalized and funded, and that the members manage the funds properly in order to run business properly. Siphoning too many assets or capital and leaving too little in the coffers to satisfy creditors or company operations may lead to a veil-piercing determination.
  • Co-mingling of funds is a bad idea in any form of corporation or LLC. Any sense of co-mingling of funds or accounts will almost certainly lead to an “alter-ego” determination by the courts or a tax regulatory board and will lead once again to veil piercing–thereby risking personal assets and stripping members of the liability and asset protection. It is a best-practices act to make certain that separate accounts are maintained and monitored.
  • The amount of discretion shown by the members should be metered to ensure that all actions are deemed to be in the best interest of the LLC or the business. Personal agenda’s should come secondary to the LLC as a whole, lest it be determined that it was formed for an express personal agenda and not a business goal.
  • The LLC should never be treated as an extended personal account of its owners or members. The courts and tax regulatory boards regularly examine the financial dealings and workings of an LLC to determine whether it is a working business or an independent profit center for its owners or members. If it is deemed an independent profit center, the veil could be pierced and there can be tax penalties and liabilities against the owner or members personally.

An LLC should pay and guarantee its own debts, unless specifically outlined in the operating agreement for specific requirements for such things as the rental or leasing of real property, etc. At times, if an owner or member regularly guarantees or pays debts, he will have been shown to act as an alter ego of the LLC and hence will cause that LLC to lose its separate entity status. Owners should not pay or guarantee the debts of their own LLC unless it is specifically outlined in the operating agreement for specified purposes.

So while a “formal” set of rules is not a requirement outlined by any state for an LLC, the concerned and astute business man or LLC member will understand that there are LLC formalities to be followed and adhered to in order to fully enjoy the benefits afforded by the LLC.

LLC Members

A member of an LLC can be compared to a shareholder or stockholder in a corporation, but with certain distinct differences. Chief among these differences is that a member can be granted voting rights in the LLC based on the percentage of capital he has invested in the LLC. This arrangement must be outlined in the Operating Agreement (similar to the “bylaws” in a corporation), along with any other rules or agreements that affect the membership in the LLC. This operating agreement must be in place before during, or shortly after the filing of the Articles of Organization.

Many states allow for the creation of single-member LLCs, while other states require two or more members, so this must be taken into consideration when forming an LLC. It is also very important to note that the IRS may apply different tax liabilities to an LLC with only one member (taxed as a corporation or disregarded entity for tax purposes) than it does to an LLC with more than one member (taxed as a partnership by default).

Typically, member shares may be sold only upon the approval of members holding a majority in interest, unless otherwise stipulated by the articles of organization or the operating agreement.

Another important consideration is that the members are directly liable for all of the LLC’s income, in proportionate amounts, regardless of whether a distribution of income was made. This is both a benefit of the pass-through taxation treatment, and an issue if there is disagreement among the members.

Managing an LLC

While the formation and structure of an LLC can be quite rewarding to its members, the proper operation and management of the LLC is not without its perils and requires careful forethought. It is never too early to consider the management style of the LLC, and the style and strategic goals should be reflected in the Operating Agreement and the structure of the LLC. As flexible and organizationally moldable as an LLC is, it is imperative that the selection of key management goals is outlined, the empowerment of certain members is delineated, and the income distribution and taxation goals be stated, as soon as is possible.  In addition, care must be taken by the Managing Member to ensure that the integrity of the LLC’s separate entity status is maintained, thereby safeguarding its tax position and the limited liability protection afforded it’s members. The LLC manager can use the company to operate nearly any business from a private equity group to a pawn shop.

Much in the same manner that Corporations can be subject to a piercing of the corporate veil by outside agencies or adverse parties in a lawsuit, the LLC can be bereft of the corporate protection if the LLC status is jeopardized because of mismanagement or misappropriation of its funds or assets. The manner in which to lose this protection is very similar to that which a standard Corporation loses its veil. If, for example, a court of law deems that the members acted in such a way that company funds were treated as their own, or if the LLC was a de-facto shield for tax evasion purposes, or if the corporate form was abused or completely disregarded by the members, then they would be considered to have lost their LLC status and would be subjected to having the LLC veil pierced. In addition, the court can also invoke the doctrine if it feels that the LLC was managed or dominated in such a way that it was wielded in order to inflict an injury, fraud, or an injustice against an outside individual, group, or organization.

It is the Managing Member’s prime directive to ensure that none of these things occur at any point during the formation or operation of the LLC. Although no proper “Corporate Formalities” apply to an LLC, the courts nonetheless expect the LLC to be managed within the parameters of a “corporate form,” with some basic premises and understandings.

There are very important points that must be considered in order to effectively manage an LLC:

  • Executing an Operating Agreement and preserving its integrity. This is the agreement that governs the operation and management of an LLC, and is the closest thing to a Corporate Formality that an LLC experiences. This is the place where all of the distribution, taxation, and goals of an LLC should be clearly outlined so that there is no question of intent as to each of these points. This is also the place where any special privileges to key members are outlined.
  • Ensure that there is adequate capitalization for the formation, operation, and maintenance of the LLC. This is another management area that comes under close court scrutiny whenever the LLC status is brought into question. Inadequate capitalization may reek of fraud to the court and may lead to a piercing of the LLC veil. It is the Managing Member’s responsibility and directive to ensure that LLC funds are properly managed, and that there is no misuse of funds or excessive or unnecessary depletion of assets by the members. Improper use of funds or leaving not enough operating capital in the coffers is a sure-fire way to attract untoward regulatory or court attention and lead to a piercing of the veil.
  • The Managing Member should ensure that there is absolutely no Co-mingling of funds. This means that in no way should any of the LLC funds be used for personal purposes or advantage by members, nor should members be directly responsible for the payment or guarantee of an LLC debt or financial obligation. Any form of personal use of corporate funds or assets will most assuredly lead to an alter-ego interpretation by the court or regulatory agencies which inevitably leads to a loss of LLC status and all the protections afforded by such status.
  • All Members should adhere to the principles outlined by the Operating Agreement, and understand that all official actions on behalf of the LLC should be applied against a “in the best interest of the LLC” standard to ensure that there are no personal agendas proffered at the expense of the health of the LLC. Any actions to the contrary can also lead to an alter-ego determination by the court and result once again in the piercing of the LLC veil.

 

Taxation is another area where effective management can lead to successfully taking advantage of all of the tax benefits afforded the members. The avoidance of excessive taxation is one of the important reasons companies choose to incorporate as LLCs, and it is of prime importance that these benefits are safeguarded through an effective Operating Agreement and efficient management. It is in every member’s interest that these benefits are preserved through effective and efficient management.

Having a proper management plan, and authoring a thorough and effecting Operating Agreement, will go a long way towards ensuring the prosperity of an LLC, and selecting a like-minded Managing Member is the best place to start.

Improperly Managing an LLC

In order to illustrate how these issues may effectively reduce or eliminate the protection from liability that is afforded by an LLC, let’s examine a couple examples:

  1. LLC Management Example – Co-mingling Funds

    John agrees to invest with IInvest LLC, of which Simon is the sole member. Under the investment agreement, IInvest LLC establishes an investment profile with 45 days duration, in which John is to recover his investment, plus a 25% bonus.

    Simon, as the sole member of the IInvest, is not properly capitalized. Simon resorts to taking loans on his home in order pay for LLC expenses rather than simply loaning the money to the LLC and issuing a promissory note. He also issues LLC checks for his personal expenses and pays for LLC operating costs from his personal account without reimbursing himself or having a promissory note from the LLC to reimburse himself in the future.

    At the end of the duration, John demands his capital investment plus the 25% bonus that was agreed to. Simon is unable to pay the capital and files for bankruptcy protection for his LLC.

    In the ensuing court proceedings, John will most likely succeed in piercing the corporate veil and can begin to recover his losses from Simon’s personal assets, including his home, investments, back accounts, vehicles, etc.

  2. LLC Management Example – Liability Protection

    Tony is the only member of SpeedyService LLC, a local package delivery service. SpeedyService LLC’s balance sheet shows a net worth of $50,000. Unexpectedly, Better Delivery Corp. opens its doors next to Delivery LLC which causes the market for SpeedyService LLC’s services to dwindle. The net worth of SpeedyService drops sharply. Tony is unwilling to add additional capital, and the company soon goes out of business.

    Jack, who lives in the same city in which SpeedyService LLC does business, is hit by SpeedyService LLC’s truck while jogging. Jack brings a suit to pierce the LLC veil of SpeedyService LLC.

    Under this scenario, Jack may try to pierce SpeedyService LLC’s veil in order to reach Tony’s personal assets.

    The application of the doctrine to pierce the veil in this manner, whether in the LLC or corporate setting, is considered a drastic remedy by most courts, particularly in instances where the owner is an individual as opposed to another business entity. Accordingly, a court will only in rare circumstances, and after much deliberation, resort to this remedy. It is also important to note that it is perfectly legal to form an LLC to avoid personal liability. Naturally, what will expose the owners is using this financial shelter to engage in criminal activity.

Members of an LLC can manage these risks by ensuring that they have a complete and proper management plan in place in the form of a well written and articulate operating agreement. They should ensure that personal business and financial affairs are maintained separate from the LLC, that personal assets and funds be maintained separate from the LLC, and that there is always adequate capitalization in order to ensure the proper operation of the business.

Each member’s ownership percentage should be clearly delineated in the operating agreement, along with any enhanced ownership rights or authorities granted to any one owner. Profit and bonus distribution should also be properly outlined in the operating agreement, along with the members’ annual draw or salary. If there are non-member employees of the LLC, their duties, rights, and responsibilities should also be a part of the operating agreement and properly listed within.

Operating an LLC

You’ve formed your LLC and are ready to reap the many tax, limited liability, and asset protection benefits afforded by the organization. What are the things to look for and look out for in order to properly run your LLC? How should it be run? Where should you start? Because of the flexibility in management styles and tax status treatment available to LLCs, there are important choices to make that bear careful consideration. It is important that your company is established and operated properly so that you can take advantage of the asset protection, lawsuit protection and tax benefits that are the advantageous features of an LLC.

There is much written about these benefits and of the LLC as a business form for the small to medium-size business owner. LLCs can indeed be a beneficial business formation because the varied options with respect to how the company is operated and taxed can fit a number of different types of businesses. One must tread carefully, however, as your choice of operation and taxation treatment can be adversely affected by the manner in which your company is run and this is primarily how the courts and/or the IRS will examine how to treat your company in the event of litigation or taxation questions.

Operating your LLC as an S Corporation

Many times members elect to have their LLC taxed and operated like an S corporation because unlike a standard “C” corporation with its double taxation issue, and the exposure to liability of a partnership, in an LLC profits and losses can pass directly through to the owner’s personal income tax return while the owner’s personal assets are shielded from liability. These are benefits that were once unique individually to either a corporation, or a partnership, but never before combined under one model. This protection, however, is not limitless–if the LLC is improperly structured or the operating agreement is poorly written with inadequate protections or language, LLC members may find themselves facing lawsuits without the personal protections, or they may find themselves being treated as a non-separate entity or alter-ego by the IRS with the commensurate tax pitfalls. It is critically important that the LLC be run in accordance with the formalities of an S corporation if it is in fact to be treated that way.

Corporation shareholders have occasionally been subject to the doctrine of “piercing the corporate veil” for things such as not adhering to the corporate formalities. The owners, in those instances, have been faced with the prospect of having their personal assets subject to an adverse judgment if a court deems that the corporate form has been disregarded or misused by its shareholders, officers, and directors. LLC members can occasionally fall prey to the same doctrine. Courts are, at times, applying the same doctrine to LLCs in what could be named the “piercing the LLC veil” doctrine. The premise of the doctrine is that no business entity should rely and utilize the entity’s financial shelters or taxation status as a tool to defraud or perpetuate a wrong against an outside entity or agency. If a business entity is deemed to have been used in such a manner, or if the owners or members of the LLC have been shown to act as if the assets and funds of the business were interchangeable with their own (co-mingling of funds such as paying one’s personal light bill with company funds), then they may lose the asset protection afforded by the former separate legal entity treatment.

Piercing an LLC veil would require the plaintiff to show that the owners or members exercised complete domination of the LLC with respect to the subject transaction or offense; and that such domination was used to commit a fraud or injustice which resulted in an injury to an outside party. In order to determine whether an LLC is “dominated” by its owners, courts will consider a number of factors, including:

  • Actions not covered in the Operating Agreement of an LLC–this is tantamount to disregarding the LLC formalities. Although an LLC is technically not required to observe formalities in the same manner that a corporation is, its actions should be completely guided by the operating agreement, and this agreement is taken into consideration by the courts and tax authorities when a determination is made as to the operation of the LLC.
  • Deficient or inadequate capitalization is another important deficiency that a court or tax regulator will examine when determining the intent of the LLC and its member’s and will usually factor heavily in their decision to pierce the veil. It is important that an LLC be properly capitalized and funded, and that the members manage the funds properly in order to run business properly. Siphoning too many assets or capital and leaving too little in the coffers to satisfy creditors or company operations may lead to a veil-piercing determination.
  • Co-mingling of funds is a bad idea in any form of corporation or LLC. Any sense of co-mingling of funds or accounts will almost certainly lead to an “alter-ego” determination by the courts or a tax regulatory board and will lead once again to veil piercing–thereby risking personal assets and stripping members of the liability and asset protection. It is a best-practices act to make certain that separate accounts are maintained and monitored.
  • The amount of discretion shown by the members should be metered to ensure that all actions are deemed to be in the best interest of the LLC or the business. Personal agenda’s should come secondary to the LLC as a whole, lest it be determined that it was formed for an express personal agenda and not a business goal.
  • The LLC should never be treated as an extended personal account of its owners or members. The courts and tax regulatory boards regularly examine the financial dealings and workings of an LLC to determine whether it is a working business or an independent profit center for its owners or members. If it is deemed an independent profit center, the veil could be pierced and their can be tax penalties and liabilities against the owner or members personally.
  • An LLC should pay and guarantee its own debts, unless specifically outlined in the operating agreement for specific requirements for such things as the rental or leasing of real property, etc. At times, if an owner or member regularly guarantees or pays debts, he will have been shown to act as an alter ego of the LLC and hence will cause that LLC to lose its separate entity status. Owners should not pay or guarantee the debts of their own LLC unless it is specifically outlined in the operating agreement for specified purposes.

Operating your LLC as a C Corporation

While not the most common election, especially so if there are multiple members, a single-member LLC can be operated, and treated for taxation purpose, as a standard or “C” corporation. Electing this method, however, will deny the pass-through benefits of the LLC and therefore negates many of the advantages of organizing your business as an LLC. Your business will be required to adhere to the corporate formalities, relinquishing the simpler LLC nature, and may be subject to increased scrutiny as a result. Some states require that a single-member LLC be treated as a C corporation, but that is not the case in every state. Tread carefully when electing to have your LLC treated as a C corporation.

Managing Risk

Members of an LLC can manage the risks involved by ensuring that they have a complete and proper management plan in place in the form of a well written and articulate operating agreement. They should ensure that personal business and financial affairs are maintained separate from the LLC, that personal assets and funds be maintained separate from the LLC, and that there is always adequate capitalization in order to ensure the proper operation of the business.

Each member’s ownership percentage should be clearly delineated in the operating agreement, along with any enhanced ownership rights or authorities granted to any one owner. Profit and bonus distribution should also be properly outlined in the operating agreement, along with the members’ annual draw or salary. If there are non-member employees of the LLC, their duties, rights, and responsibilities should also be a part of the operating agreement and properly listed within.

Operating your LLC following the basic guidelines outlined above, and using good business and common sense, will ensure that your LLC functions and is treated as it was intended to.

LLC Operating Agreement

An operating agreement for an LLC is an agreement among its members about the business of the LLC, the rights and duties of the members, and any special arrangements that are agreed to before hand. Operating agreement are not a strict requirement of any state, but they are considered a “best practices” procedure and are highly encouraged.

The operating agreement can be compared or likened to the by-laws of a corporation or the partnership agreement in a simple partnership–it outlines the rules, regulations, and business practice of the LLC and it’s members, and can be used to override the default rules imposed upon an LLC by a state’s LLC act. An example of this type of override is when a particular member contributes a significant percentage of the operating capital to the LLC and the other members agree that this member should have increased voting power–this can be proportionate to the amount invested, or any number that the membership agrees upon, but it would be formalized as part of the operating agreement.

If the LLC is formed as a single-member LLC, the operating agreement is a declaration as to the structure and organization that the member has chosen for his company, and is an important key in determining how the IRS will treat the LLC for tax purposes.

Other key issues that should be addressed in the operating agreement are as follows:

  • Capital or asset contributions by the members
  • Taxation planning
  • Accounting model (i.e. accrual, cash or modified cash basis)
  • Record and minutes keeping
  • Frequency of member meetings
  • Management structure
  • Officer appointments
  • Buy-out provisions
  • Management rights, duties, and obligations
  • Date of LLC dissolution (some states require dissolution date)
  • Any special resolutions, voting rights, or operational duties and requirements

These are but a sample of the types of provisions, resolutions, and issues that should be addressed in the operating agreement, and it is a best practices procedure to include any significant LLC operational duties and responsibilities in the operating agreement.