CorporateDIrect FullLogoWhiteLetter

800-600-1760

Are You a California Resident?

Are you a California Resident?
You: I am out of your state for six months and a day!
California: Hold my non-alcoholic beer!

Many people believe that as long as they are outside the state of California for six months and a day they are not residents of California. And thus don’t have to pay California’s high income taxes. But the state of California is both broke and arrogant. And they make the rules the way they want.

The short answer is that you must be in your ‘home state’ more days than in your California home to avoid the state’s taxation. And for those who like to travel, tramping to Europe, New Zealand and the Nevada side of Lake Tahoe for just half the year won’t work with California’s wide, casting net.

What follows is a more technical explanation of California’s Franchise Tax Board (“FTB”) position on the issue. Please know that the FTB has more attorneys on the payroll than you do.

THE FTB’S DETERMINATION OF CALIFORNIA RESIDENCY

According to the FTB, a California resident is any individual who meets either of the following:  (1) present in California for other than a temporary or transitory purpose; or (2) domiciled in California, but outside California for a temporary or transitory purpose. As such, a California nonresident is any individual who is not a resident; and a part-year California resident is any individual who is a California resident for part of the year and a nonresident for part of the year. See, FTB Publication 1031, Guidelines for Determining Resident Status (2021), p. 4.

Residency is significant because it determines what income is taxed by California. The underlying theory of residency is that you are a resident of the place where you have the closest connections. These connections include, but are no means limited to, the following:

  1. amount of time you spend in California versus amount of time you spend outside California;
  2. location of your spouse and children
  3. location of your principal residence
  4. state that issued your driver’s license
  5. state where your vehicles are registered
  6. state where you maintain your professional licenses
  7. state where you are registered to vote
  8. location of the banks where you maintain accounts;
  9. the origination point of your financial transactions;
  10. location of your medical professionals and other healthcare providers (doctors, dentists, etc.), accountants, and attorneys;
  11. location of your social ties, such as your place of worship, professional associations, or social and country clubs of which you are a member;
  12. location of your real property and investments;
  13. permanence of your work assignments in California. In using these factors, it is the strength of your ties, not just the number of ties, that determines your residency. See, FTB Publication 1031 (2021), p. 5.

Generally speaking, your state of residence is where you have your closest connections. If you leave your state of residence, it is important to determine if your presence in a different location is for a temporary or transitory purpose. You should consider the purpose and length of your stay when determining your residency.

When you are present in California for temporary or transitory purposes, you are a nonresident of California.

For instance, if you come to California for a vacation, or to complete a transaction, or are simply passing through, your purpose is temporary or transitory. As a nonresident, you are taxed only on your income from California sources.

When you are in California for other than a temporary or transitory purpose, you are a California resident.

For instance, if your employer assigns you to an office in California for a long or indefinite period, if you retire and come to California with no specific plans to leave, or if you are ill and are in California for an indefinite recuperation period, your stay is other than temporary or transitory.

As a resident, you are taxed on income from all sources. You will be presumed to be a California resident for any taxable year in which you spend more than nine months in this state.

Although you may have connections with another state, if your stay in California is for other than a temporary or transitory purpose, you are a California resident. As a resident, your income from all sources is taxable by California. See, FTB Publication 1031 (2021), p. 6.

HOW THE FTB APPLIES THE SO-CALLED “SIX-MONTH PRESUMPTION”

There is widely thought to be a “six-month presumption” in California residency law to the effect that, if you want to avoid becoming a resident of the State of California, then all you need to do is to spend less than six months in California during any calendar year. Although the amount of time you spend in California does play a critical role in determining your legal residency, the real rule is more complex.

There is, indeed, a “six-month presumption,” established by regulation, that if a taxpayer spends an aggregate of six months or less in California during the year, and is domiciled in another state, and has a permanent abode in the domicile state, and does nothing while in California other than what a tourist, visitor, or guest would do, then there is a rebuttable presumption of non-residency.

As such, the real rule, established by regulation, is that the so-called “six-month presumption” consists of an aggregate of 183 days. Thus, if you spend a total of more than 183 days in California during any calendar year, then you are not entitled to the presumption. Furthermore, in order to qualify for the presumption, you have to be a domiciliary of another state and have a permanent home there (owned or rented).

For residency law purposes, “domicile” is defined by case law and the regulations as “where an individual has his true, fixed, permanent home and principal establishment, and to which place he has, whenever he is absent, the intention of returning.” If you are not a domiciliary of another state, and if you do not have an abode there, then you are not entitled to the six-month presumption. Furthermore, in order to qualify for the presumption, you must have only the kinds of limited contacts a tourist or visitor might have.

The FTB regulations envision this as restricted to owning a vacation home, having a local bank account, and joining a country club. Thus, if a taxpayer has any other contacts, there is no presumption. Furthermore, the presumption is rebuttable. As such, even if you meet all the requirements for the establishing the presumption, the FTB still is entitled to offer evidence to prove that you are a California resident. In addition, there is yet another presumption (otherwise known as ‘stacking the deck’) that the FTB’s rulings are correct, which you then must also rebut.

Despite these formal considerations, it should be noted that, as a practical matter, the FTB uses a “ledger analysis” in determining California residency. Under this “ledger analysis,” the FTB literally makes a ledger with three columns. One column itemizes your time spent in California; a second column itemizes your time spent in your home state; and a third “other” column itemizes your time spent elsewhere.

The FTB then compares your “California column” with your “home state column.” If you spent more time in your home state than you spent in California, then you prevail in the time category; and if you spent less time in your home state than you spent in California, then you lose in the time category. The idea is that the place where you spent most of your time (not necessarily the majority of the year) is more likely to be your home than not.

BRIEF DISCUSSION

Applying the California FTB’s so-called “ledger analysis” to the problem at hand, the problem may be restated, as follows: if you spend three months of the year in the State of Nevada (presumably in the “home state” column); you spend three months and a day of the year in Europe (presumably in the “elsewhere” column); and say, for example, you spend four months of the year in California (presumably in the “California” column), then it is easy to see that you spent more time in the State of California than in your “home state” of Nevada (the “elsewhere” column is not really relevant).

Thus, your stay in the State of California is not “temporary or transitory,” because you spent more time in the State of California than in your “home state” of Nevada. The underlying rationale is that the place where you spend most of your time (and not necessarily the majority of the year) is more likely to be your home than not.

CONCLUSION

As a practical matter, the California FTB applies a “ledger analysis” in determining California residency, and what really matters is that you must spend more time in your “home state” than in California.

One sure way to avoid all the FTB’s technical considerations for asserting their taxation is to sell your California home and move to another state.

Design Your Asset Protection Plan

You design a lot of things in your life. The layout of your house, the flow of your business, the requirements on your children, and many more scenarios are all elements of conscious design.

Asset protection is no different. There is an architecture, a cohesive structure, to your properly planned legal safeguards. Sometimes you try and do it yourself, which could be fine. Many people are into DIY. And yet, with all the asset protection misinformation on the internet, you’ve got to be careful. Does that overpriced ‘guru’ really know what they’re doing? You won’t know until the plan they’ve designed holds. Or fails.

Designing your asset protection plan does not improve with setting up more entities than you need. When your plan is solid with three LLCs, who benefits by adding 5 more LLCs to the mix? I know you will answer that question correctly.

Your effective design should never be a matter of confusion to you. If you don’t understand what your asset protection planner is suggesting, demand a clear explanation. If they respond that most attorneys and no clients will ever understand their ‘brilliant’ structure, get up and walk out. That’s not how it works. As well, if you ask to get a second opinion from another lawyer about the plan and they claim that no lawyer will even begin to comprehend what they’ve put together for you, as a special client and part of the elite inner circle, it is also time to leave. You need to clearly understand the plan. And so does your spouse.

Sometimes, like an old bridge, a plan design has fault lines. The structure appears fine, until it collapses under pressure. This can be the case with land trusts. Promoters tout them for their asset protection benefits while they offer no such feature. To cover this inconvenient issue, they suggest that one or more land trusts be beneficially owned by one LLC. The structure appears as follows:

Land Trust Structure

How will this structure hold up?

When a tenant in the duplex is injured on the property, they have the ability to sue the land trust for their damages. Some promoters claim that the tenant will never know the owner of the land trust because such information is confidential. Without exaggeration, this is one of the greatest legal fallacies in history. If the tenant’s attorney can’t locate the land trust owner all they have to do is publish notice of the lawsuit in the paper. It is very easy to do. And if the owner doesn’t respond to the lawsuit the tenant can win by default. You’ve lost the case and they are foreclosing on the property. “Well,” says the land trust promoter as they close shop and move 1,000 miles away, “I guess that didn’t work.”

Contrary to what these promoters may suggest, you don’t want to hide. You actually want to be found if needed, so that you can receive the notice of a lawsuit. You want to promptly turn the claim over to your insurance company so they can defend you and hopefully settle the case. If you hand them the claim after a default is entered in virtually all cases they don’t have to cover you. You didn’t give them proper notice of the lawsuit. Your design flaw is not their problem.

There is another design flaw in the structure above. Let’s say the promoter acknowledges that an LLC needs to be in the mix for its benefits of limiting liability. So, the beneficial owner (a required feature of land trusts and akin to a shareholder in a corporation or a member in an LLC) is listed as XYZ, LLC. When Land Trust #1 is sued by the tenant the liability flows to the beneficial owner, or XYZ, LLC.

Now if XYZ, LLC were on title to the property instead of the land trust, the liability would be contained within that one LLC. But in our design flawed structure, the liability flows from the land trust into the LLC. What does the LLC own? Not only Land Trust #1 but also Land Trust #2 and Land Trust #3. So the tenant can also get what the LLC owns, which is equity in all three land trusts. “Well,” says the land trust  promoter as they prepare to move to Alaska, “that didn’t work either.”

As is clear, the design of your asset protection plan really does matter. When building it listen to your little voice, the one that is always there and always protective. If the proposed plan doesn’t make sense, if it doesn’t add up, think again. Get another opinion. Your asset protection is too important to be left to unquestioned amateurs.

Corporate Direct, on the other hand, does not advise using land trusts or any overly complicated structures. We have been in the business of asset protection for over 30 years and we can help you structure your entities correctly and in a straight forward and affordable manner. Get your free 15-minute consultation to get started today!

Corporate Opportunities

Does the Rule Apply to Real Estate?

If you invest in and/or syndicate real estate what are the duties to your investors? You owe them a duty of loyalty. But how far does that go?

The issue of corporate opportunities is important. I wrote a whole chapter on it (from which part of this is excerpted) in my newest book “Veil Not Fail.” Before discussing its applicability to real estate lets review it in a business setting.

The simplest case involving a breach of the duty of loyalty is where a corporate executive expropriates for themself a business opportunity that rightfully belongs to the corporation. For example, assume that a company distributes window shades but a key executive takes the exclusive distributorship rights for a new type of awning. The corporation should have obtained the distributorship. It is in their core business.

The duty of loyalty requires officers and directors to apprise the corporation (or LLC or LP) of “corporate opportunities.” The corporation gets to decide if it wants it or not. If the company doesn’t move forward then the executive may be free to pursue it, or not. The decision may be at the company’s discretion.

A corporate opportunity is any investment, purchase, lease or any other opportunity that is in the line of the corporation’s business, and is of practical advantage to the corporation. If an officer or director embraces such opportunity by taking it as their own, they may violate their duty of loyalty, especially if by doing so their self-interest will be brought into conflict with the corporation’s interests. Will the officer be loyal to the company or their own business? The conflict is clear.

During their time in office, officers will likely discover business opportunities for the corporation. The officer may also have personal business opportunities that are somehow related to the corporation’s business. For example, if the officer is an inventor who focuses on telecommunications products, they will likely be interested in all such business opportunities. The corporation may be able to pursue some opportunities the officer discovers for the corporation, others it will not. If the corporation turns down one opportunity is the officer then able to pursue it?

Delaware courts have established a test for corporate opportunities. If an officer’s self-interest comes into conflict with the corporation’s interest, the duty of loyalty can be breached. The law will not permit an officer to pursue opportunities (1) that the corporation is financially able to undertake, (2) that is in the line of the corporation’s business, and (3) that is of practical advantage to the corporation.

On the other hand, if the corporation is not financially able to embrace the opportunity, has no interest in the opportunity, and the officer does not diminish their duties to the corporation by exploiting the opportunity, then the person may be allowed to pursue the opportunity.

Evidence that the opportunity was presented directly to the individual, and then not shared with the corporation, may be used to show that the corporate opportunity rules were not followed. In most states, the simplest way to avoid a problem is to present the opportunity to the corporation and allow it the chance to pursue or reject it. If the corporation cannot or will not take advantage of the opportunity, the employee, officer, or director may be free to pursue the opportunity.

Though formal rejection by the board is not strictly necessary, it is safer for the whole board to reject a corporate opportunity. The decision shouldn’t be based on individual board member’s opinions. There must be a presentation of the opportunity in some form.

After the corporation has rejected the opportunity, and before pursuing the opportunity, the employee, officer, or director should unambiguously disclose that the corporation refused to pursue the opportunity and ensure that there is an explanation for the refusal.

Resignation before completion of the questionable activity may not constitute a defense to liability arising from a corporate opportunity. Courts have found liability even where officers and directors resigned before the completion of the transaction. Although there are no certain guidelines for determining which opportunities belong to the controversy and liability may be avoided if officers use rigorous caution regarding corporate opportunities.

But again, what about real estate opportunities? Many syndicators are pursuing several investments at the same time. They always owe a duty to do their best. But does that prevent them from pursuing new projects without involving every investor?

The key to this issue is clarity. In a real estate based LLC Operating Agreement it must be stated that the principals are free to go after any investment. While existing investors may be offered the right to invest in future projects (always a good marketing technique) the syndicators must be allowed the freedom to pursue any and all opportunities for their own account.

Check your Operating Agreement and Offering Documents to make sure this important language is included.

Checkbook IRA

Checkbook IRA – Checkbook LLC

Whatever You Call It –There’s Trouble Ahead

A recent case has shed light on one of the riskiest retirement plan strategies put forth by promoters. In McNulty v. Commissioner (157 T.C. 10) a U.S. Tax Court brought clarity to the scheme of using self-directed IRAs for personal investments. While the rules are strict, they had become lax and unenforced in recent years. The McNulty case brings the requirements back into line, and serves as a warning of what may come.

If you have a checkbook IRA or LLC you may want to speak with your lawyer immediately.

The facts in McNulty are fairly common. We have seen such promoters at investment conferences for years.

In August 2015 Mrs. McNulty purchased services from Check Book IRA, LLC (Check Book), through its website, that included assistance in establishing a self-directed IRA and forming an LLC to which she would transfer IRA funds though purchases of membership interests and then purchase American Eagle (AE) gold coins using IRA funds. During 2015 Check Book’s website advertised that an LLC owned by an IRA could invest in AE coins and IRA owners could hold the coins at their homes without tax consequences or penalties so long as the coins were “titled” to an LLC.

So, Mrs. McNulty used the company to set up Green Hill Holdings, LLC (Green Hill) to own the coins. Green Hill was then owned by her IRA.

There were a few problems with this. First, an IRA trust must be administrated by an independent trustee, not the beneficiary of the retirement assets. The trustee is responsible for storing the coins in an adequate vault. In this case, Mrs. McNulty, following the promoter’s advice, took personal possession of the coins herself and held them in her own safe at home.

McNulty and the IRS made numerous arguments and counterarguments as to why the whole chain of events was either appropriate or amiss. The court could have decided the case on a number of issues but chose just one — this is important and we will come back to it.

The Tax Court noted that an owner of a self-directed IRA is entitled to direct how her IRA assets are invested without forfeiting the tax benefits of an IRA, and that a self-directed IRA is permitted to invest in a single-member LLC.

However, IRA owners cannot have unfettered command over the IRA assets without tax consequences. The Tax Court stated that it was on the basis of Mrs. McNulty’s control over the American Eagle coins that she had taxable IRA distributions.

A qualified custodian or trustee is required to be responsible for the management and disposition of property held in a self-directed IRA. A custodian is required to maintain custody of the IRA assets, maintain the required records, and process transactions that involve IRA assets.

The presence of such a fiduciary is fundamentally important to the statutory scheme of IRAs, which is intended to encourage retirement saving and to protect those savings for retirement.

The Tax Court emphasized that independent oversight by a third-party fiduciary to track and monitor investment activities is one of the key aspects of the statutory scheme; that when coins or bullion are in the physical possession of the IRA owner (in whatever capacity the owner may be acting), there is no independent oversight was clearly inconsistent with the statutory scheme; and that personal control over the IRA assets by the IRA owner was against the very nature of an IRA.

The Tax Court concluded Mrs. McNulty had complete, unfettered control over the American Eagle coins; that she was free to use them in any way she chose; and that this was true irrespective of Green Hill’s purported ownership of the American Eagle coins and her status as Green Hill’s manager.

Once Mrs. McNulty received the American Eagle coins, there were no limitations or restrictions on her use of the coins, even though she asserted that she did not use them. While an IRA owner may act as a conduit or agent of the IRA assets, an owner of a self-directed IRA may not take actual and unfettered possession of the IRA assets. It is a basic axiom of tax law that taxpayers have income when they exercise complete dominion over it. Constructive receipt occurs where funds are subject to the taxpayer’s unfettered command and she is free to enjoy them as she sees fit.

The Tax Court concluded that Mrs. McNulty’s possession of the American Eagle coins was a taxable distribution. Accordingly, the value of the coins was includible in her gross income. The Tax Court noted that the McNultys’ arguments to the contrary would make permissible a situation that was ripe for abuse and that would undermine the fiduciary requirements of the act. Mrs. McNulty took position of the American Eagle coins and had complete control over them. Accordingly, she had taxable distributions from her IRA in excess of $300,000 — a painful financial mistake.

We have long warned about the risks of the check book scheme. In my 2015 book Finance Your Own Business the hazards were enumerated with the conclusion being “The safer course is to stay away from Checkbook IRAs.”

Interestingly, some promoters claim that the McNulty case is limited to situations in which gold coins were taken into personal possession. But that narrow view misreads the whole case. (Indeed, if they argue otherwise ask for a legal opinion letter on the viability of the Checkbook LLC.)

Remember when we said the court chose just one issue as a discussion point? The court mentioned numerous prohibited transactions (rule violations) and problems with the Checkbook scheme. But it focused on just the physical possession of the coins in this specific case.

The court may be doing everyone else using a Checkbook IRA a huge favor. The court may be signaling that future limitations on the scheme are coming. The court may be giving everyone a head’s up that its time to change your Checkbook IRA structure.

Be sure to talk to your own attorney about this. But here is a scenario to consider: Let’s say you are the manager of the LLC that controls your IRA investments. As such, you have management control over your IRA assets. You are keenly aware that the court in the McNulty case stated: “Personal control over the IRA assets by the IRA owner is against the very nature of an IRA.”

So to clean things up you need to step aside as manager of the Checkbook LLC. You appoint your CPA or attorney or other fiduciary as the manager so that you no longer have any personal control over your retirement assets.

If the IRS ever later questions you on such a move you tell the truth. You had initially been led to believe that the Checkbook IRA scheme was acceptable. But then you learned of the McNulty case. And in an attempt to follow IRS guidance you appointed a new, non-related fiduciary to serve as the LLC manager overseeing your personal IRA investments. You have made a good faith effort to be compliant with their rules in light of new information. Instead of doing nothing, by taking prompt corrective action you are in a much better position to ask for forgiveness.

The McNulty case is not the only challenge to the Checkbook LLC. Proposed legislation in Congress also seeks to crack down on IRA abuses. Talk to your professionals now to stay ahead of what is coming.  

Piercing the Corporate Veil – How to Avoid It

50% of piercing the veil court cases nationwide succeed because owners are failing to properly follow corporate formalities. This exposes business owners to personal liability – meaning they can lose their possessions.

What is the Corporate Veil?

What is the corporate veil? How can it protect me and what does it mean when it is pierced? We’ll cover these ideas critical to liability, wealth and asset protection. By properly forming a corporation, LLC or Limited Partnership (LP) and taking the steps required of corporate formalities, a corporate veil is raised that may protect shareholders, officers and directors from personal liability and provide tax benefits. However, to ensure that the corporate veil remains intact and business meets its potential, all persons involved in the corporation must follow certain corporate formalities. (While we refer to corporations in this article, the concepts and issues apply to LLCs and LPs as well. Don’t be misled by those who claim that the need for following formalities only applies to corporations.)

If you fail to follow the requirements of corporate formalities, you could be vulnerable to court decisions which pierce the corporate veil. Today, 50% of piercing the veil court cases succeed because owners are failing to properly follow corporate formality requirements.

This topic is so important, I wrote a book on it!

Veil Not Fail

Upcoming book!

When protective entities like LLCs and corporations fail and businesses risk piercing of the corporate veil, experienced legal guidance is imperative. In Veil Not Fail, the author explores potential risks and weak spots in LLCs and corporations and helps readers better prepare for what he considers an inevitability in a sue happy society ― it isn’t if you’ll be sued…it’s when.

Ebook prelaunch, April 2022 at

RDA-Press.com

 

Definition of Piercing the Corporate Veil

A situation in which courts put aside limited liability and hold a corporation’s shareholders or directors personally liable for the corporation’s actions or debts. Veil piercing is most common in close corporations. While the law varies by state, generally courts have a strong presumption against piercing the corporate veil, and will only do so if there has been misconduct like abuse of the corporate form (e.g. intermingling of personal and corporate assets) or undercapatitalization at the time of incorporation. (Undercapatitalization would apply if the corporation never had enough funds to operate, and was not really a separate entity that could stand on its own).

If corporate formalities such as annual corporate filings and meeting minutes are not maintained in a timely and proper manner, courts can hold YOU, the entity’s owner, personally responsible for claims filed against the company. You need to keep your corporation filings current, and your legal protections intact.

How to Prevent Piercing the Corporate Veil

Limited liability and tax benefits are not a right granted to every business person, but privileges earned by following corporate formalities. The following nine rules provide general guidance for maintaining the corporate veil while conducting business through a corporation:

  • Perform all annual filings;
  • Maintain internal formalities, including having a resident agent in their state of formation and in any state the company qualifies to do business in;
  • Maintain a written record of corporate decisions;
  • Provide the world with corporate notice;
  • Ensure the corporation is sufficiently capitalized;
  • Maintain the distinction between corporate assets and personal assets;
  • Use caution when distributing corporate profits;
  • Separate bank accounts; and
  • Separate tax returns

Although the burden of maintaining corporate formalities may not be appealing, the consequences of neglecting corporate formalities are great. Whether the corporation has followed the foregoing rules becomes important when a creditor seek to receive payment through the assets of the corporation’s individual shareholder, director or officer. Each rule and its various implications are discussed more in depth below.

If you are unsure if you are in compliance or would like hire Corporate Direct to ensure that you are, we offer a service to assist.

Get Our Corporate Clean-Up Service

  • We prepare your first Corporate Minutes.
  • We perform the research and analyze if you are current in all areas of the corporate formalities and whether or not your entity is positioned for full protection.
  • We do all the work necessary to bring your affairs current to verify you are legally compliant and you save time.

We have helped clients become compliant after as much as 23 years of improper record keeping. But remember, it’s important to have the corporate veil properly maintained before a lawsuit or claim is brought against a corporation. Once that happens, its too late and personal assets can be jeopardized.

How to Raise the Corporate Veil

Once you have decided that a corporation, LLC or Limited Partnership (LP) is the right entity for your business or asset holding purpose and you have decided which state to incorporate in, corporate formalities begin. Events occurring immediately after formation must be performed properly to maintain the corporate veil and ensure the corporation’s longevity and flexibility.

A corporation is born when the Articles of Incorporation are properly filed. The corporate veil provided Shareholders with limited liability and is raised and maintained by management and ownership that treats the corporation like a corporation. As indicated above, a corporation is considered to be a legally distinct entity, capable of incurring its own debts and obligations. This protection is frequently referred to as the corporate veil. When creditors or others seek to obtain a judgement from a court that makes the corporations shareholders, directors or officers personally liable, they are seeking to pierce the corporate veil. This article will focus mostly on maintaining the corporate veil once it has been established, but briefly here are the requirements needed to set it up:

  • File the Articles of Incorporation
  • Hold organizational meetings to empower the corporation to conduct business and provide limited liability.
  • Provide the corporation with competent initial management
  • Issue the corporation’s shares of stock

Maintaining the Veil by Maintaining Corporate Formalities

Performing Annual Filings

Annual filings are required to protect and ensure the longevity of the corporation. In addition to the permits, licenses, or approvals that are unique to the corporation’s business, every corporation must obtain and maintain a corporate charter in good standing. In many states, a corporation must file an annual report, providing the names and addresses of Officers and Directors, and annual fees. If such filings are not completed in a timely fashion, the state may revoke the corporate charter and the corporation will cease to exist. The time, energy, and expense expended organizing the corporation will be wasted if the state revokes the corporate charter. While it may be possible to have the charter reinstated, the best way to maintain the corporate veil and ensure that the corporation serves its purpose is to simply perform annual filings in a timely manner.

Maintaining Internal Formalities

Bylaws adopted by the Directors in their organizational meeting provide the guidelines for the corporation’s future actions and corporate policy. Specifically, the Bylaws should provide the following:
1. Notice requirements for Directors meetings;
2. The minimum number of annual Directors meetings;
3. The date for annual Shareholders meetings;
4. The requirements for special Shareholders meetings;
5. The responsibilities of each Officer and Director; The procedures for removing Officers or Directors;
6. The procedures for Shareholders’ inspection of the corporation’s records; and
8. The name and address of the corporation’s resident agent.

Although they shape the internal operations of the corporation, Bylaws should not be complicated or provide intricate procedures. Necessity determines the extent and detail provided in the corporation’s Bylaws, which may be amended, altered, or repealed by the Board of Directors.

All decisions the corporation makes and all actions the corporation takes should be in compliance with the rules established by the Bylaws. Compliance with the Bylaws indicates that the corporation’s Directors, Officers, and Shareholders treat the corporation as a separate entity with its own rights and limitations. If the Directors, Officers, and Shareholders treat the corporation as a separate entity, courts will be less likely to ignore the division between corporate property and the rights of the individual Directors, Officers, and Shareholders. The corporate veil will be maintained.

As well, in most states it is imperative to have a current resident agent to accept service of process. Failure to have a resident agent in place can lead to arguments that the corporate veil should be pierced.

Maintain a Written Record of Corporate Decisions

Even if a small group of people or a single person controls the corporation, it should conduct meetings and prepare records of such meetings. Shareholders and Directors conduct three types of meetings, which should each be recorded through minutes of meetings. As provided above, immediately following incorporation, organizational meetings should be conducted. During the corporation’s life, regular meetings must be conducted annually pursuant to the corporation’s Bylaws to reflect elections and the corporation’s other decisions. Additionally, a corporation may hold special meetings when called by the Directors or Shareholders. Special meetings are held to discuss urgent items of business or to approve any legal or tax issues. The general procedure for conducting Directors or Shareholders meetings is provided below.

Prior to a meeting of Shareholders, all Shareholders must receive or waive notice of the meeting. Prior to a Directors’ meeting, all Directors must receive or waive notice of the meeting. In meetings of Shareholders or Directors, corporate formalities require voting and an official record of actions taken at the meeting. The official record of actions taken in regular meetings, as well as the organizational meetings, is provided as the minutes of the meeting. Minutes provide a record of the corporation’s resolutions. A resolution is a document that records actions that the Directors or Shareholders “resolve” to take on the corporation’s behalf. The nature and timing of the corporation’s decisions dictate whether a resolution or minutes of a meeting provide an appropriate record of a decision.

An alternative in most states to conducting actual meetings and preparing minutes for those meetings is for the corporation to authorize action by written consent. This is the quickest and easiest way to document formal corporate action. Directors and/or Shareholders sign a document that contains the language of the corporation’s decision or resolution. By signing the document, the Directors and/or Shareholders approve the decision or resolution. To ensure that an action by written consent is adequately documented, all Directors and/or Shareholders must sign the consent form. The corporation should keep signed consent forms in the corporate minute book.

By conducting the necessary meetings and preparing adequate records, a corporation provides documentation to protect the corporate veil. Should a creditor seek to pierce the corporate veil at a later date, the corporation’s records will serve as evidence of its separate existence. In addition, maintaining proper records may help to avoid future miscommunications and misunderstandings within the corporation.

Although many people believe that preparing annual meeting minutes is difficult, the minor inconvenience is greatly outweighed by the potential problems that failing to prepare such records could cause. If necessary, a service provider may prepare the required minutes for the corporation for a reasonable fee. Our firm charges $150 per year to prepare minutes. You may call toll free 1-800-700-1430 for more information.

Provide the World with Corporate Notice

Whenever the corporation enters into a contract or engages in any business activity whatsoever, it must do so clearly as a corporation. Individual Officers or Directors may be subject to personal liability if they act on the corporation’s behalf, but fail to clearly indicate that they are acting in their capacity as the corporation’s Officer or Director. To avoid creditors or others from piercing the corporate veil and attacking individual members of the corporation’s management or Shareholders, it must be clear that the corporation, and not an individual, is acting. Business cards, letterhead, invoices, company checks, brochures, etc … must identify the corporation. The full name of the corporation should be provided (not XYZ, but XYZ, Inc.). All contracts and correspondences signed by Directors or Officers for the corporation should be signed with reference to their corporate designation. If the corporation takes steps to ensure that others know that the corporation, and not an individual Officer or Director is acting, the corporate veil will be more resistant to attack.

Avoid Under-Capitalization

Although most jurisdictions will not allow creditors to pierce the corporate veil solely because the corporation had insufficient assets, the risk of veil piercing provides reason to ensure that the corporation is sufficiently capitalized. California and few other states have relied on under¬capitalization in piercing corporate veils. A corporation should have sufficient resources to meet its short-term obligations whether it is just starting, is part of a cooperative project, or is merely one element in a greater corporate strategy. If the corporation is undercapitalized, a creditor may argue, and a court could accept the argument, that the corporation exists simply to help its owners shelter their assets. As is discussed further below, this may be enough reason for a court to pierce the corporate veil and find personal liability for Officers, Directors, and/or Shareholders.

Maintain the Distinction between Corporate and Personal Assets

A common but fatal mistake for developing corporations occurs when its management and/or Shareholders fail to maintain the distinction between corporate and personal assets. Whether arising from loans from the corporation to individuals, shared bank accounts, shared tax returns, or individual use of corporation property, failure to separate corporate assets from personal assets negates the corporation’s separate identity. To prevent creditors from piercing the corporate veil, the corporation must maintain a separate bank account, file separate tax returns, and use corporate assets only for corporate purposes.

The corporation should not be used as a lender for its Officers, Directors or Shareholders. An air of impropriety is created when a corporation loans money to members of management, even if management genuinely intends to repay the loan. The infamous chain of corporate scandals in spring and summer 2002 highlighted the dangers involved in loaning to management, as such loans were often cited in allegations that a Director or Officer breached their fiduciary duties. The best way for the corporation to avoid potential problems is to refuse to lend money to its Directors and Officers.

Regardless of their personal interest or role in the corporation, nobody should treat the corporation’s property as personal property. By clearly distinguishing between corporate and personal assets, the corporation may indicate and retain its separate identity. By reporting and maintaining the corporate assets separately from management’s or Shareholders’ personal assets, the corporation will reduce the potential for successful lawsuits against Officers, Directors, and individual Shareholders.

Cautiously Distribute Corporate Profits

Whether a corporation distributes its profits through dividends paid to shareholders or compensation paid to employees, the corporation’s distribution of profits may provide a basis for creditors to pierce the corporate veil. The veil that limits the liability of Shareholders, Directors, and Officers also creates limitations on the corporation’s ability to pay such corporate actors from the corporation’s profits. If the corporation fails to obey established rules for the distribution of corporate profits, a creditor may use such failure as an indication that the corporate actors are not treating the corporation as a separate legal entity. To reduce creditors’ ability to pierce the corporate veil, the corporation must exercise caution in distributing its profits.

Every state authorizes a corporation’s Board of Directors to issue dividends to its Shareholders. However, the Directors’ decision to declare dividends may result in substantial fines assessed against the individual Directors if the dividend is found to be illegal. Dividends from surplus cannot exceed limits established by reference to the corporation’s assets. “Nimble” dividends, or dividends paid from profits, may be issued when the corporation’s surplus is insufficient. However, such dividends may only be paid when such payment does not impair the capital representing preferred stock. Directors must determine whether the corporation has sufficient funds legally available to pay dividends to protect themselves from potential liability. To avoid liability arising from the issuance of dividends, corporations should consult with legal counsel before deciding to issue dividends.

Keep a Separate Bank Account

A corporate veil will be pierced in cases where the company founders use a personal bank account for business affairs. You cannot consistently pay business expenses from a personal account and, conversely, you cannot pay personal expenses from a company bank account. Failure to follow these simple guidelines can be catastrophic, so as soon as you incorporate obtain an EIN (Employer Identification Number) from the IRS and use it to open a corporate bank account.

Prepare a Separate Tax Return

Because you have obtained an EIN for your entity you must now file a separate tax return with the IRS. Fear not, this is your chance to take all the deductions you may be entitled to take. But failure to file a separate return can lead to claims that you are not following corporate formalities. So file – and take advantage of the tax benefits you are entitled to in the first place.

Many developing corporations do not have sufficient assets or profits to distribute dividends to Shareholders, but they must compensate Officers, Directors, or other employees for their services. Especially in start-up businesses, the compensation a corporation pays to Officers, Directors, and other employees may determine the corporation’s ability to succeed. Equity compensation (using shares of the corporation’s stock, stock options, or other alternative forms of compensation) may be attractive. Compensation based in part on the corporation’s profits may also be appealing. However, all forms of compensation should be based primarily upon the market value of the employee’s services. The Internal Revenue Service may scrutinize excessive compensation paid to Directors, Officers, or employees and decide to tax excessive compensation as dividends.
Corporations that over-compensate their employees may create liability for the Directors based on Shareholders’ claims of mismanagement, breach of fiduciary duties, self-dealing, or waste of corporate assets. Through a derivative action, the Shareholders may regain control of the corporation and its assets. The corporation may then assert legal claims against former Directors, creating personal liability for such Directors. To avoid potential liability based on employee compensation and excessive tax liability, Directors must ensure that compensation paid by the corporation is reasonable.

All decisions regarding the distribution of a corporation’s profits or compensation for employees is subject to the discretion of the Board of Directors. However, to avoid potential liability for the corporation and for themselves, Directors must carefully consider the effects of every use of the corporation’s assets. Caution and the advice of legal counsel may be necessary to prevent the Board’s distribution decisions from creating unwanted liability.

State Differences

Some states are more likely to pierce the corporate veil than others. As well, in some states veild piercing cases are brought more often. The top five states in order of most cases filed are:

  1. New York,
  2. California,
  3. Texas,
  4. Ohio and
  5. Pennsylvania.

As you would expect, the filings reflect population density. But they also reflect the states in which the strategy may be successful.

On a national basis, nearly 50% of veil piercing cases were successful, which is all the more reason to be cautious when dealing with corporate formalities.