Congratulations on the launch of your own business. For many, becoming the boss is the realization of a life long dream. Your business reflects your values and aspirations. It bears your fingerprints. It is your vision made real.
But your business isn’t you.
There are many reasons that small businesses take the form of an S-Corp or LLC. They may involve taxes, or succession planning, or liability protection. They may be a combination of these reasons. But whatever the reasons, the goal is to make it clear that the business has a life of its own.
It is not you.
I realize it is tempting to think that doesn’t matter. But it does. If you don’t operate like a business, then in a dispute, a court or mediator can find that your company is merely your “alter ego.” In this situation (known as “piercing the corporate veil”) you will become personally liable for all the debts and obligations of the company.
1. Don’t treat the company bank account like your personal bank account. If you need to withdraw funds, it is either a loan or an owner distribution, and needs to be reflected properly on the books and records. Commingling of funds and assets is often one factor used to pierce the corporate veil. Any owner distributions must be made pro rata based on ownership, so funds must be distributed to all of the owners, not just the one who needs the money. (Each of these approaches have tax ramifications which should be discussed with your tax adviser.)
2. There are only 2 ways to put money into the company. You can either make a loan to the company which is memorialized with a promissory note and minimum interest is charged if required by the IRS, or make an additional capital contribution. If your business needs additional funds, make sure to also discuss this with your CPA or tax adviser to consider the best way to get the money into the business.
3. Make sure to sign everything in the name of the company and not you personally. If your company enters into a lease or other contract, the document should be in the name of your business and you should sign as the President, manager, or other appropriate title. You should not enter into any contracts in your individual name.
4. Make sure to have adequate insurance and cash reserves for your business operations. Talk with your insurance broker about what types of commercial liability, errors and omissions and loss coverage is appropriate for your business. Often business owners don’t realize what insurance they need until something happens and they don’t have adequate coverage. Make sure that you keep adequate cash reserves for the operation of your business and unexpected occurrences. Small companies often underinsure, undercapitalize, and rely on the owner to make up for a lack of cash in the business. This makes your business look more like your “alter ego” and less like a true stand-alone business.
5. Have Annual Meetings and Follow Other corporate formalities. The board of directors of a corporation must appoint the officers each year and the shareholders must elect the directors each year. This can occur at a duly noticed meeting or by written consent. Make sure to calendar this requirement each year. In addition, major actions or decisions of a corporation, such a purchasing real estate, expanding the business, hiring key employees, etc., should be approved by the Board of Directors and sometimes even the shareholders. Although limited liability companies have fewer corporate formalities, many actions still require consent of management and sometimes the owners, depending on the provisions in the operating agreement for the LLC and statutory requirements. These decisions should be reflected in minutes from a duly noticed meeting or by written consent.
There are many other factors to consider when operating your business and a short article like this can not attempt to address them all. Your legal and tax advisers can guide you. However, most of the companies that I’ve seen struggling with alter ego problems have violated at least one of these basic guidelines. Being aware of the issues is a great way to avoid problems.