Corporate Formalities: Essential Steps to Protecting Your Business

In today’s business environment, especially when operating multiple entities under a single ownership or control, maintaining corporate formalities is crucial. Properly observing these formalities helps ensure the limited liability protections of a corporate structure remain intact. Failing to do so can expose owners and affiliated entities to liability through what is known as “veil piercing.” Here’s a guide on how businesses can protect themselves by adhering to key corporate formalities.

General Guidelines for Protecting Your Business:

1. Maintain Separate Financial and Operational Records:

• Ensure that each entity has distinct books, records, bank accounts, and financial statements. Avoid the commingling of funds between entities.

• Each entity should file its own tax returns, reflecting its independent operations.

2. Regular Governance and Documentation:

• Hold regular board/member meetings and document key decisions with detailed minutes. Follow all governance procedures outlined in the formation documents of each entity.

• Obtain proper authorizations for transactions between entities, supported by formal agreements and thorough documentation.

3. Adequate Capitalization:

• Ensure that each entity is adequately capitalized to meet its business obligations. Avoid draining assets from subsidiaries or other entities, as this could jeopardize their ability to function independently.

4. Clear Entity Identification:

• Use proper entity names, letterhead, and branding in all communications and contracts. It should always be clear which entity is acting in any transaction or correspondence.

• Keep operational distinctions, such as separate employees, office spaces, and phone numbers, for each entity wherever possible.

5. Insurance and Risk Management:

• Maintain appropriate insurance policies tailored to the specific needs and risks of each entity.

6. Segregation of Management Roles:

• Avoid having officers or directors of parent entities directly manage the day-to-day operations of subsidiaries. Each entity should be independently managed, according to its governance structure.

Specific Best Practices for Observing Corporate Formalities:

1. Inter-company Loans/Transfers:

• Document all inter-company loans or transfers with formal loan agreements specifying terms and conditions.

• Charge market interest rates and require board approval, recording the transaction in meeting minutes.

• Maintain separate accounting records that clearly track loan balances.

• Example: If one entity lends $100,000 to another, there should be a loan agreement specifying the interest rate, repayment terms, and purpose of the loan. This should be recorded in both entities’ financial statements, and regular payments should be made in accordance with the agreement.

2. Shared Services:

• Establish formal agreements that detail the services provided and the fees charged between entities.

• Ensure that fees reflect fair market value, and maintain time records and invoices to support all charges.

• Example: If one entity provides HR services to another, there should be a service agreement that outlines the specific services provided, the hourly rate, and how costs will be allocated.

3. Employee Sharing:

• Use formal employment or secondment agreements when employees are shared between entities.

• Track the time employees spend working for each entity and charge entities appropriately based on this time allocation.

• Example: An employee working 60% for one entity and 40% for another should have their salary allocated accordingly, with appropriate documentation supporting the allocation.

4. Office/Equipment Sharing:

• Draft formal lease or usage agreements between entities for shared office space or equipment.

• Charge fair market rent or usage fees, supported by proper documentation.

• Example: If one entity uses office space owned by another, there should be a lease agreement specifying the rent, payment terms, and duration of the lease. Payments should be documented and made on time according to the agreement.

5. Contracts:

• Clearly identify the contracting entity in all agreements.

• Obtain proper authorizations based on each entity’s governance documents, ensuring that officers of parent entities do not sign on behalf of subsidiaries without proper authority.

• Example: A contract should clearly state which entity is the contracting party. If the contract requires board approval, that approval should be documented in the board meeting minutes.

6. Marketing/Branding:

• Maintain clear separation between entity brands to avoid confusion.

• Implement trademark or licensing agreements for any shared branding between entities.

• Example: If two entities use a shared brand, there should be a licensing agreement specifying how the brand is to be used, royalties (if any), and the rights of each entity.

7. Intra-group Management Fees:

• Implement formal agreements for management services provided by one entity to another.

• Ensure that management fees are based on market rates and reflect the actual services provided.

• Example: If one entity provides management oversight to another, there should be an agreement outlining the scope of services and the fee structure.

8. Asset Transfers:

• Ensure that any transfer of assets between entities is supported by proper documentation, such as purchase agreements or bills of sale.

• Obtain fair market value for assets transferred and document the valuation process.

• Example: If one entity sells a piece of equipment to another, there should be a bill of sale, and the price should be supported by an independent valuation or appraisal.

9. Intellectual Property Sharing:

• Create formal licensing agreements for the use of intellectual property (IP) between entities.

• Ensure that IP usage is tracked and that royalties or fees are paid as per the agreement.

• Example: If one entity holds a patent that another uses, there should be a licensing agreement specifying the terms of use, royalties, and duration.

10. Joint Ventures or Collaborations:

• Clearly define the roles and responsibilities of each entity in joint ventures or collaborative projects.

• Document financial contributions and profit-sharing arrangements in a formal agreement.

• Example: In a collaborative real estate development project, there should be a joint venture agreement outlining each entity’s investment, the management structure, and how profits or losses will be shared.

Conclusion

By rigorously following these guidelines and properly documenting inter-company transactions, businesses can maintain the necessary legal separation between entities. This approach significantly reduces the risk of veil-piercing claims. The key is to treat each entity as a truly separate business, both in practice and on paper.