TRAPS FOR THE UNWARY, OF WHAT SHOULD THE OWNER OF AN ONGOING BUSINESS BE AWARE?
© 2001 By Douglas E. LoMonte
In the area of legal and tax compliance of ongoing businesses, Murphy’s Law governs. Just when you need a document to complete a major transaction, you find out that some incidental oversight has put the whole deal on hold.
• The bank’s lawyer wants a Certificate of Good Standing and you can’t get one.
• The accountant for your prospective joint venture partner discovers that your S-corporation has a corporate shareholder.
• Your lawsuit is dismissed because you failed to register your company in the state where the lawsuit was filed.
Don’t let it happen to you!
If you’re the owner of an ongoing business, you should know that there exist a number of legal and administrative traps for the unwary. We hope that this article will help you identify and avoid some of the most common traps.
Failure to File Annual Reports. Virtually every state requires corporations and limited liability companies to file annual reports. Generally, the Secretary of State (or equivalent) reminds you to file by sending you a form to fill out and return, along with the filing fee. In Connecticut, the mailings coincide more or less with the month during which your business was organized (i.e., your anniversary month). Failure to timely file an annual report may result in the inability to secure a certificate of good standing (at best) or revocation of your corporate status (at worst). Keep in mind that if you move or change your mailing address, you may not receive the Secretary of State’s reminder. Unfortunately, we’ve found that the Post Office does not always abide by its commitment to forward mail for a full twelve months. And it’s no defense that you didn’t receive the mail. Make sure that you file the appropriate change of address forms with the Secretary of State of each state in which your business is registered. Call us if you’re not sure how or when to file your annual reports.
Failure to Register in Other States. If you conduct business in a state other than your domiciliary jurisdiction, you may be required to register as a "foreign corporation" with that state’s Secretary of State (or equivalent). Keep in mind that registering with the Secretary of State is not the same as tax registration. Don’t assume that because you’ve registered with the Revenue Department for wage withholding or sales tax, that you’re okay. In most cases, the Revenue Department will not communicate your existence to the Secretary of State. Exactly what activities will require you to register as a foreign corporation? Forests of trees have been sacrificed to publish the many court decisions and scholarly analyses attempting to answer that question. Here are a few pointers:
• If you have an office with employees, you probably need to register.
• If all you do is have a bank account, you probably don’t need to register.
• If you do strictly mail order and have absolutely no other connection, you probably don’t need to register.
• If all you do is have a directors’ meeting at a resort, you probably don’t need to register.
Absence of a Shareholders’/Members’ Agreement. If your firm has been operating successfully and you have one or more partners or shareholders, we strongly recommend that you adopt a written shareholders’ (for corporations) or members’ (for LLCs) agreement. Why? Here are just a few reasons.
• Without an agreement, you may not be able to control the disposition of an ownership interest in the event of death, disability, retirement or withdrawal (i.e., a "triggering event").
• An agreement can provide for seamless management succession.
• An agreement can provide for the financial means your partners will eventually need to purchase your interest (i.e., your exit strategy).
• If you contemplate selling your business, an agreement can enhance your business’ value by assuring the buyer of an experienced and stable management team.
• An agreement can protect you from competition for business and/or employees by a former partner/shareholder.
• An agreement can help to preserve your valuable S-Corporation election (see below).
Disqualification as an S-Corporation. Under most circumstances, transfer of stock to a corporation, trust or non-resident alien (i.e., no green card) results in immediate disqualification as an S-Corporation under the Internal Revenue Code. Here are examples of some circumstances to watch out for (and prevent by means of a Shareholders’ Agreement):
• A shareholder dies and leaves her stock to a brother in England.
• A shareholder sees an estate planning attorney who advises him to place his stock in a trust.
• A shareholder files for bankruptcy and a corporate creditor is awarded ownership of her stock.
Inattention to Corporate Formalities. A principal advantage of incorporating your business is the statutory liability shield. If you’re not careful, however, you can lose the benefit of that shield by failing to observe corporate formalities. Minutes of annual shareholders’ and directors’ meetings clearly demonstrate your intention to maintain your corporation as an entity with its own identity separate and apart from you as an individual. In many states, including Connecticut, annual meetings of shareholders are required by statute. Other corporate formalities include maintenance of separate accounting records and checking accounts and establishment of a separate office. Observance of corporate formalities typically becomes an issue when a plaintiff sues the shareholders of a corporation on a claim related to a corporate debt or tort. Members and managers of LLCs are not subject to a statutory annual meeting requirement but are judged by the same rules as corporations when it comes to determining whether to pierce the statutory liability shield.
If you have any questions about this article, please email to dlomonte@wsdb.com .
