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Preventing Personal Liabilitiy of Shareholders: The Importance of Maintaining Corporate Formalities

Create a corporation and limit liability, right? Not necessarily. There are specific requirements under California law which must be met in order to maintain a corporation. These requirements are commonly referred to as “corporate formalities.” Corporate formalities are the basic rules and procedures for governing and operating a corporation. As a result, a corporation cannot simply be created and then forgotten. If an unfortunate event occurs and the corporation is liable, the shareholders must ensure they remain protected from personal liability. This can only be accomplished with specific actions observing all corporate formalities required by law and statute.

What Is Required to Create a Corporation?

The most essential requirement for creating a corporation recognized by California law is to file Articles of Incorporation with the Secretary of State. Once the Articles have been filed, the Secretary of State will provide the corporation with an entity number. In turn, the entity number is used to obtain a separate tax identification number for the corporate entity. Each corporation must also create bylaws, which govern the conduct of business affairs and how the business is managed. Following its creation, the corporation must have a first meeting of the shareholders and directors at which time directors are elected, the bylaws are adopted, and any actions taken to create the corporation are approved. The actions of this meeting and each subsequent meeting (of shareholders and/or directors) must be in writing and kept as a record by the corporation. Following the creation of the corporation, shares must be issued to each of the shareholders.

It is important to make certain specific actions are taken from the beginning of the corporation to ensure the liability of each shareholder is limited. One important action is the creation of a separate bank account in the name of the corporation. The funds of the shareholders and the corporation should not be comingled as the comingling of funds is one of the primary factors in which shareholders become liable for corporate debts or actions.

It is best to have an experienced lawyer do the initial organization, filings and meetings to ensure that all legalities are complied with.

How Must a Corporation Be Maintained?

As noted previously, a corporation cannot simply be created and then ignored. In order to maintain an active corporation with the Secretary of State, specific requirements must be met. For example, the corporation must annually file a Statement of Information with the Secretary of State. Failure to do so could lead to the suspension of the corporation’s powers, rights and privileges. In addition, failure to pay the California Franchise Tax for the corporation can lead to the suspension of the corporation.

Beyond these filing requirements, which are grounds for suspension, shareholders must also ensure that there is an annual meeting of the shareholders pursuant to Corporation Code section 600. The date and time of this meeting will be set forth in the corporate bylaws. In contrast with the requirement for an annual meeting of shareholders, the Corporations Code only requires a “regular” meeting of the board of directors. (Corp. Code, § 307.) Despite not being a requirement, the corporate bylaws often include a provision for an annual directors meeting immediately following the shareholders meeting. It is a good practice to have these meetings once a year in order to demonstrate conformance with the corporate formalities set forth in the Corporations Code.

One additional corporate formality is that major corporate decisions must be approved by shareholders (such as mergers and appointment and removal of directors) or by the board of directors alone in the case of financial decisions of the company (such as buying and selling corporate assets and borrowing or lending money). Generally these decisions are discussed and approved at a special meeting of the shareholders whereby the act is ratified and approved before it is undertaken.

As with the initial incorporation it is best to have a lawyer remind the principals of the corporation that it is time for the called for meetings of the Board and shareholders and do the filings of the reports required by law.

What Happens If a Corporation Fails to Observe Corporate Formalities?

Ultimately, the ramifications of failing to observe corporate formalities can be dire for the shareholders of that corporation. If formalities are not observed, the shareholders may be held personally liable if the shareholder(s) and the corporation can be shown to be essentially one and the same and the corporation was never a separate corporate entity. This argument often arises in cases where the shareholders are using corporate funds as their own and fail to keep good records of the corporate finances. Similarly, the failure to hold annual meetings and record all major decisions of the corporation can be used to support the argument that the corporation was never a separate entity.

The best practice for keeping a corporation in good standing and protecting shareholders from individual liability is to keep good and up-to-date corporate records of the corporation’s actions. Because proper maintenance of corporate formalities is essential to maintain limited liability, as stated above, it is best to consult an experienced attorney both before incorporation as well as throughout the corporation’s existence.