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Mihevc: Steps required by law to preserve corporate status

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Many family owned and operated businesses in McHenry County are organized as corporations under Illinois law. A family business owner who operates his or her business as a corporation must take the steps necessary to maintain corporate legal status in order to receive the legal protection afforded by Illinois law and to preserve the tax status of the business.

Family business owners typically choose the corporate form of existence based on the limited liability for the equity owners of the business; the decentralization of management; the ability to raise capital; the transferability equity interests; and tax considerations.

These goals are jeopardized if the business fails to follow the steps required by law to preserve corporate status. Contract parties, creditors, personal injury plaintiffs, IRS auditors and other claimants will examine the validity of the corporation to determine whether they can look through the corporate form to reach its shareholders. Personal shareholder liability can be disastrous for the business owner both professionally and personally.

Under Illinois law the shareholders of a corporation are generally not liable for the debts and obligations of the business. However, Illinois courts will disregard the corporate form and hold the shareholders of a corporation personally liable if (1) there is such a unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist; and (2) if the adherence to separate corporate existence would sanction a fraud or promote injustice. Disregarding the corporate entity and holding the shareholders personally liable for corporate obligations is known as “piercing the corporate veil.”

In deciding whether to pierce the corporate veil, courts will focus on a number of factors, which include inadequate capitalization; non-payment of dividends; insolvency of the corporation; nonfunctioning of the officers and directors; absence of corporate records; commingling of funds between the corporation and its owners; diversion of assets from the corporation by or to a shareholder; failure to maintain arm’s length relationships among related entities; and the corporation functioning as a mere façade for the operation of the dominant shareholders.

Many of these factors are difficult pitfalls to avoid for the family owned and operated business. However, sound business practice requires the family business owner to avoid any of these traps in order to maintain the corporate legal form.

A corporation must file its annual report with the secretary of state, pay its annual fee, and file and update other forms required by the secretary of state. The corporation should maintain and update its corporate record and hold meetings of shareholders and directors as required by the by-laws and Illinois statute. The corporation should issue stock and maintain stock records, pay dividends, maintain proper accounting and financial records, and file taxes and forms as required by the IRS. The corporation should also document its contracts and leases and formally adopt shareholder and director resolutions for major decisions.

IRS auditors, claimants, potential business purchasers, lenders and others typically review the corporate minute book to determine whether various corporate activities were adequately documented, whether shareholders had a meeting, whether directors and officers were properly appointed, and whether activities and major decisions such as borrowing, paying bonuses and dividends entering into substantial contracts or leases, were all properly authorized and executed.

Shareholders must treat the corporation as a legal and financial entity separate and distinct from the individual shareholder. Common mistakes include commingling personal and corporate funds, using corporate funds for personal use, and dealing with third parties individually rather than through the corporation for purposes of signing contracts or obtaining credit.

Shareholders must provide adequate capitalization for the corporation at the time of formation and must maintain adequate capitalization as the business grows and evolves.Capitalization is usually adequate if the amount of actual business capital on hand is sufficient for the corporation to pay its debts as they become due.

For most family businesses in today’s hyper-competitive marketplace, the last thing on anyone’s mind is holding annual shareholder and director meetings, maintaining thorough records and updating the corporate record book. However, sound business practice requires the business owner to observe corporate formalities and maintain adequate records in the ordinary course of business to maintain limited liability and corporate tax status.

Business owners might consider calendaring corporate maintenance at least twice per year. Opportune times for this process may include one month before the date of the annual meeting of shareholders as required by the corporate by-laws, and one month before the end of the corporation’s fiscal year.

• Chad Mihevc is a partner with the law firm of Flores & Mihevc , LLC based in Deerfield and McHenry, and can be reached at chad @floresmihevc.com. Flores & Mihevc focuses on business law, commercial real estate and banking law.

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