Formation and Governance of Your Business – Why Is It So Important?

By: Daniel A. Perry

When it comes to operating your business correctly, there are several legal items that require every business owner’s attention. No matter how many times I explain the importance of formation and governance of a business’s legal entity, I have discovered that a story works much better to explain the legal importance of this concept.

Starting a company

Let me introduce you to John’s Plumbing Company. John Doe started a plumbing company about five years ago. Business was tight in the beginning, and he operated on a shoestring budget. Now five years later, John’s Plumbing Company is thriving and has five full-time employees.

About two years into John’s business really started to grow, he realized he needed to organize the business, business financing, and accounting. John hired a business attorney to incorporate his business and an accountant to work on his books and records.

Prior to this, John was depositing all his business assets into his personal bank account and using his personal bank account to pay all expenses. Afterall, he was the business and performed all the work on this business himself.

The benefits of an LLC

John’s business attorney recommended that he formally incorporate his business as a Limited Liability Company. In John’s situation this would be the most beneficial from an asset protection perspective and a tax perspective. At that point in time, John was operating as a sole proprietor. So if the company was sued, John would also be sued because he was the company. If this happened, all his personal assets would be at risk for loss, including his home, bank accounts and retirement accounts.

In addition, as a single member LLC — meaning that John is the only owner — all his profits and losses woul flow through to his individual 1040 income tax return each year. From John’s perspective, this was more beneficial than a corporation as he would only be taxed once on profits. A corporation, on the other hand, is taxed on the profits at the corporation level, and then taxed again on the distribution to the shareholders/owners.

John saw the benefit and established the John’s Plumbing Company, LLC, and the attorney completed the necessary legal work to formally incorporate John’s business. The attorney recommended that John open a separate bank account in the name of John’s Plumbing Company, LLC and that John segregate his business assets and expenses from his personal assets and expenses. Also, the attorney recommended that John only sign contracts with customers and vendors in the name of John’s Plumbing Company, LLC and that John complete his annual corporate minutes every year.

Why you should complete annual corporate minutes

Annual corporate minutes are extremely important because it provides a track record that a corporation is active and preserves limited liability and prevents personal assets from being at risk in the event of a lawsuit. The annual minutes simply summarizes the year and discusses any major changes to the company for the upcoming year. The attorney directed John to contact him once a year so that the annual corporate minutes were completed.

It’s now five years later, and John’s business is thriving. However, in year five, John and John’s Plumbing Company, LLC had some unexpected news. It turned out during John’s first two years of business, he invested some money in local advertising. This turned out to be a cash-burning exercise, and John ended up not paying the advertiser a total of $15,000. John had completely forgotten about it, but the advertiser did not. John would periodically receive collection letters in the mail but would ignore them. Eventually, he had to do something about them.

John finally decided to schedule an appointment with his business attorney. He brought a copy of the lawsuit with him. The attorney first questioned the validity of the debt, John confirmed it was.

While looking over the lawsuit, the attorney asked John if he’d completed his annual minutes as recommended over the last three years. John admitted that he had not done so, and the attorney suggested contacting the opposing attorney and seek to settle this lawsuit without any further litigation.

John was perplexed as to why they would do this. The first step in any lawsuit is to file a formal answer with the court. This is typically a general denial of the allegations made in the lawsuit and raises any applicable defenses to the legal action.

In addition, the next step is referred to as discovery. This is a part of a legal action where the parties are required to exchange evidence that may be used at trial. One of the first discovery requests the Plaintiff issues are for production of documents and to supply all corporate records for John’s Plumbing Company, LLC.

The Plaintiff would see that John did not record his annual minutes and therefore was failing to follow corporate formalities. When the opposing attorney saw the lack of corporate records over the last three years, the Plaintiff would seek to hold John personally liable for the debt. This would mean that all of his personal assets were at risk, including his home, personal bank accounts and retirement accounts.

Another concern is that this debt was incurred before he formally incorporated John’s Plumbing Company, LLC. The attorney was slightly surprised that the company was sued, and John was not sued personally. However, once they got into the discovery process, that was unlikely to last. He fully expected John to be named personally in this lawsuit.

The attorney recommended they contact the opposing attorney and attempt to settle the legal action to avoid having John be personally named in the lawsuit later in the case. John agreed, and the case settled for approximately $12,000.

What you should do as a small business owner

No matter how many times I speak with business owners and stress the importance of being legally sound from day one, many businesses simply do not ensure this. Formally establishing your business is just step one. You must ensure that your business is always legally sound, including maintaining separate bank accounts, always maintaining and updating corporate records annually, and having employee handbooks and employee policies updated annually, just to name a few.

Having a business attorney that knows your business can often mean the difference between spending a few thousand dollars in legal fees and spending a few hundred thousand dollars in legal fees!

For more information

If you have questions about legal issues affecting your own business, or you are looking to have a general counsel for your business, please contact our office for a conversation, and we can discuss your business law and general counsel needs.

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