Corporate Governance and Maintaining the Corporate Veil

The purpose for incorporating (C corp., S corp., LLC) a business is to protect investors (stockholders, owners, etc.) from personal liability for corporate (business) debts. To enjoy such protection, the corporation must be maintained in a certain manner.

• Valid Incorporation. The corporation must be set up correctly, according to laws of the state it is incorporated in. This typically means filing articles of incorporation in duplicate with the secretary of state. This is, in effect, an application for a corporate charter. If accepted, the state will issue a certificate of incorporation. Then the board of directors named in the application must meet to adopt bylaws, elect officers and transact such other business as may come before the meeting.
• Conduct Business on a Corporate Basis. This entails following requirements of the state the business is incorporated in. This typically means holding regular directors meetings, maintaining a corporate book with minutes of meetings, keeping corporate funds separate from funds of stockholders, and maintaining financial records on the business. For closely held corporations, the requirements may be relaxed. Check the laws of the state your legal entity is incorporated in and see Closely Held Corporation below.
• Provide Adequate Financial Basis for the Business. This typically means shareholders invest sufficient capital to meet reasonably anticipated requirements of the business. But once the business is initially capitalized, investors are not obligated to contribute additional dollars, even if the entity has financial trouble.
• No Illegal Activity. If the business is used to commit fraud, officers and directors can be held personally liable.

In addition, when executing agreements for the corporation, officers and directors must clearly sign in the name of the corporation — as corporate representatives and not individuals. The corporation also must file its own tax return, separate and distinct from individual return(s) of the owner(s).

Closely Held Corporation

Most companies are closely held, meaning that they have few shareholders, and shareholders serve as directors and officers. The result is a flattened corporate structure like the following:

Figure 1. Management Structure of Typical Closely Held Corporations

The result is that many statutory requirements of corporations — such as annual meetings of shareholders, elections of directors and appointment of officers — are simply formalities. Therefore, most small companies do not even bother. But failure to “act like” a corporation and adhere to legal requirements may result in forfeiture of limited-liability status. Fortunately, many states have enacted laws that relax nonessential governance requirements for closely held corporations. Such laws permit operation without a board of directors, broad use of shareholder agreements, waiver of annual meetings, and execution of documents by a single person acting in more than one capacity, such as chairman of the board and president.

To operate under these relaxed rules, some states require that the corporation both qualify as a closely held corporation (typically fewer than 50 shareholders) and elect “statutory close corporate” status. To avoid potential loss of the corporate veil, it’s critical that you understand the laws of the state your company is incorporated in and abide by them.