Last week we discussed the organization and setting up of your business. This week we will discuss the operation of your business and how corporations and limited liability companies (LLCs) can protect your personal assets from business debts and lawsuits.
You have filed the articles of incorporation or organization with the state so you think have a valid corporation or LLC. If you are like most business owners, you have organized your business as a corporation or LLC to add a layer of creditor protection. You know that with a properly organized corporation or LLC, you can protect yourself from most business creditors in the event your business fails or gets sued. In that situation, only the assets of the business can be attached, not your personal assets
But does your corporation or LLC have that protection? When starting up your new business, you may be tempted to organize it on your own without the aid of an appropriate professional legal advisor. However, what you may not know is that if you do not properly organize your corporation or LLC and/or do not act like a corporation or LLC, the protections that you thought were there, are not.
Most new business owners do not know that it takes more than just filing articles of incorporation or organization with the state to properly set up the corporation or LLC. The filing of the articles is only the first step in setting up your business.
Firstly, there are provisions for your corporation or LLC that are not in the state printed forms. If you just fill in the blanks in the online forms, you may be missing out on some additional provisions to limit your liability or aid in the management of your business.
For example, with a corporation, you can put in additional creditor protection provisions to add additional layer of protection for your directors. With an LLC, you can designate whether the LLC is member-managed or manager-managed. If an LLC is member-managed, any member has the authority to enter into contracts or agreements to bind the LLC. If you have a manager-managed LLC, the members elect a member o non-member manager, who manages the day-to-day operations of the LLC.
On many occasions, I have even seen company organizational documents attempted to be prepared by non-attorney professional advisors such as tax preparers or accountants. These advisors apparently think that all you need to do is fill in some blanks on forms obtained online or from an office supply store. In 30 years of my practice, I have never seen non-attorney prepared business organizational documents completed properly.
Setting up a business on your own is kind of like wiring a house. You can go to the building supply store, get the instruction books, buy your materials and wire it yourself. But there is always going to be a risk of electrocution or a fire. Similarly, with a corporation you can attempt to do it yourself, but if you do not follow all the rules and the laws, the risk you run is unlimited personal liability for business debts and lawsuits.
One of the most common mistakes that I see with new business owners is that after the articles have been filed with the state, no documents are ever prepared granting ownership interests in the business. Corporations need shareholders and LLCs need members. Stock certificates must be issued to the owners of the corporation, who are called shareholders or stockholders. To document the ownership interests of an LLC, you can either issue membership certificates to each of the owners, who are called members, or list the ownership percentages in an LLC operating agreement.
If your corporation or LLC never issues any ownership interests, it has no owners. And if your company has no owners, who owns the business? If you get sued, it could be determined that you are operating the business as a sole proprietor or general partnership. As we discussed last week, as a sole proprietor or general partner you have unlimited personal liability for all business debts and lawsuits, whether or not you caused them. You could lose your house, savings accounts and other assets in the event of a catastrophic business creditor. This is called piercing the company veil. When this occurs, the company provides no creditor protection to the owners.
When setting up a corporation, you should have a complete and comprehensive set of bylaws that set forth management structure and govern the operation of the corporation. You must have organizational meetings in which the incorporators authorize the issuance of the stock. After the stock certificates are issued to shareholders, they have their initial meeting to begin operations and elect directors of the corporation. The directors also must have an organizational meeting to implement the business plan and elect the officers which consist of a president, secretary and a treasurer, and may include one or more vice-presidents. The officers manage the day-to-day operations of the corporation.
With an LLC, the organizers must meet to determine the issuance of membership interests. Once the membership interests are issued, the members must meet to enter into a comprehensive operating agreement which governs the management of the LLC and to elect managers, if any.
Once you have setup as a corporation or an LLC, you must keep up with annual formalities of the organization or risk personal liability for company debts. There are annual filings that must be kept up. Often overlooked with corporations is the requirement of annual shareholder and director meetings. Although not required, it may be wise to have annual meetings of the members of your LLC to show that you are acting as an LLC.
Whenever you are acting on behalf of the corporation or LLC, make sure that the persons with whom you are dealing do not think they are dealing with a sole proprietor or partner. Make sure you use inc., corp., ltd., LLC or similar designations whenever you are dealing on behalf of the business. Put it on business cards, stationary, advertising, promotional pieces, websites, invoices, checks and any other written business materials. If it is determined in a lawsuit that you have not acted like a corporation or LLC, then your business creditors may be able to pierce the company veil and go after your personal assets to satisfy business debts and lawsuits.
If you have a co-owner, you may want to set up your business 50/50, so each owner has an equal say in the business. This is all well and good. But what if you cannot agree on a decision with your co-owner? In that instance, you may be stuck with inaction and deadlock all decisions of the company. Your only recourse may be court proceedings.
When setting up a company with two owners, I recommend that you put some sort of deadlock protection in your bylaws or operating agreement. You could add a minority owner who owns 5% or 10% of the company who would be the swing vote to create a majority. You could also set it up with one owner having 49% and the other with 51%, so that if there is a disagreement, the 51% owner rules. Another alternative is for the owners to appoint an independent third party to be the tie-breaker in the event of an owner deadlock.
If there is more than one owner, you should also have a comprehensive buy-sell agreement for when one owner leaves the company through death, disability, retirement or any other reason such as the owners just cannot get along. Without a comprehensive buy-sell agreement, you may end up in court when a co-owner leaves. This could result in tens of thousands of dollars in legal fees. It’s like the old Fram oil filter commercial, “Pay me now, or pay me a lot more later.” We will be discussing more about business exit strategies next week.
You can minimize your personal liability risk by properly setting up your business using professional legal advisors who are familiar with business laws and also individual and business taxation matters. As we discussed last week, the choice in selecting which entity that you use, be it a corporation, an S corporation or an LLC, is determined by your particular business and tax situation. If your business attorney is not familiar with taxation matters, have your business attorney consult with your tax advisor to determine which type of entity is the best for you.
I have heard people say they can’t afford the thousand dollars or so that it would cost to pay an attorney to properly set up the corporation or LLC. One of the most common reasons that small businesses fail is because they are under-capitalized. If you cannot afford to pay an attorney to properly set up your corporation, you might want to rethink starting your business right now. You probably are under-capitalized and would be unable to fund a start-up business. You may want to wait until you have sufficient funds to start the business. Protect yourself, protect your family, protect your assets by properly organizing your business.
By Matthew M. Wallace, CPA, JD
Published edited October 23, 2016 in The Times Herald newspaper, Port Huron, Michigan as: Protecting yourself from business creditors