Why keep your minutes and other records updated?
1. The Law Requires Corporate Minutes to Be Kept. The California Corporations Code requires each corporation to keep adequate and correct written minutes of shareholder and board of directors proceedings (Corporations Code § 1500). Failure to comply with this statute may, in certain cases, result in negative consequences.
2. Creditors May Directly Sue the Shareholders for Corporate Obligations and Acts if the Corporate Veil Is Pierced. One distinct advantage of conducting business as a corporation is that only the corporate assets may normally be reached by creditors for payment of obligations or other types of liability of the corporation, resulting, for example, from personal injury, property damage or breach of contract. This protection is lost, however, if a court determines the corporate veil should be pierced and shareholders held personally liable for such obligations.
Two of the common methods by which the corporate veil may be pierced are: (i) where the shareholders have treated the corporation as their alter ego rather than as a separate entity; and (ii) where it would be unjust to uphold the corporate entity and allow shareholders to escape personal liability.
Failure to keep adequate corporate minutes is one factor in not satisfying the requirement of maintaining corporate formalities and creates the possibility of personal liability. The law provides the personal liability protection in the form of the shield of the corporation, but in turn the shareholders and directors must comply with certain formalities.
Many cases cite the failure to keep corporate records as a significant reason for holding shareholders liable. For example, in one case, the court entered a personal judgment against the president — a 93 percent shareholder — in favor of a former shareholder who lent money to the corporation. During the last three years of operation, the corporation failed to keep minutes, held no shareholder or board of directors meetings, and elected no officers or directors.
In another case, a sole shareholder was held liable to a creditor where the minute book entries were very meager; the shareholder failed to inform the creditor he was dealing with a corporation, and the corporation was inadequately capitalized.
Similarly, in a third case, the court held the shareholders personally liable on corporate contracts where the corporation failed to hold regular meetings or to keep current minutes, and where the shareholders entered into personal transactions with the corporation without prior approval of the board of directors or documentation (a common occurrence in closely held corporations).
3. Proper Corporate Minutes Help to Avoid Allegations of Self-Dealing and Shareholder Conflicts of Interest. In corporations with two or more shareholders or directors, it is essential that the approval of the board of directors be formally given prior to a transaction in which any shareholder, director or officer deals with the corporation as an individual. These transactions are common, and include, for example, compensation arrangements, leases, stock option agreements, and the purchase or sale of assets. Without such prior approval, it is much easier for the shareholder or director who is not involved to make a claim against that participant personally, arguing that the transaction was unfair to the corporation.
4. The Internal Revenue Service Emphasizes Accurate and Complete Corporate Minutes in Its Audit Procedures. The Audit Manual of the Internal Revenue Service (IRS) indicates that examining agents routinely begin an audit with an examination of the corporate minutes. Our experience verifies this. If the minute books are complete, the rest of the audit is more likely to go smoothly.
An IRS audit exposing deficient corporate minutes may have any or all of the following results:
(a) The corporate status of an otherwise legitimate corporation may be disregarded for tax purposes, with the shareholders taxed on corporate income at their individual rates plus denial of corporate deductions. Simply because an entity is a corporation under state law does not guarantee the IRS will also treat it as a corporation. When the IRS chooses to ignore the corporate status, it will tax the individual shareholders on the corporation’s income at the shareholders’ regular rate, and may also disallow corporate tax deductions.
(b) Corporate deductions for salary or other compensation paid to shareholders, directors or other employees may be denied. Adequate corporate minutes are a distinct advantage to the taxpayer in an audit when legitimizing corporate deductions for compensation. Corporate minutes are considered strong evidence of the character of payments particularly to related parties. For example, the IRS may take the position that payments to an owner will be treated as dividends and the company (C corporation) taxed at the corporate level.
Moreover, the language used in the minutes is very important. In one case, a corporation was denied a deduction for compensation paid to an employee simply because the minutes stated the payment was for appreciation of services rendered, rather than specifically for salary or compensation.
(c) Loans between the corporation and shareholders may be recharacterized to the taxpayer’s disadvantage. Problems often arise when there are corporate loans to a shareholder or shareholder loans to the corporation. The IRS will often argue that the loans to the company are equity contributions and that the loans from the company to the shareholder are taxable compensation. Here formalities are especially important.
With loans between the company and the shareholder, the IRS and the courts look first to whether the loan is evidenced by a promissory note and second, if the loan was authorized in the corporate minutes. If there is no evidence, the IRS then looks more closely at the transaction, which may result in its recharacterization.
Where a corporation loans money to a shareholder, the shareholder would normally receive a deduction on interest paid as part of the loan repayments. In many cases, however, the IRS recharacterizes the transaction, labeling the loan amount as a dividend, which is not deductible by the corporation and is considered income to the shareholder. Furthermore, any interest included in repayment of the loan by the shareholder would not be deductible to the shareholder, but would be considered merely a contribution to capital of the corporation.
In the situation where a shareholder loans money to the corporation, the corporation should normally receive a deduction for the interest portion of the repayments. However, where the IRS has recharacterized the transaction as a shareholder contribution to capital, the corporation loses the interest deduction and the repayment to the shareholder may be treated as a dividend taxable as compensation with payroll withholding requirements.
(d) An IRS finding of tax liability may result in interest, penalties and fines. Where an IRS audit determines that additional tax is due, interest will be assessed based on the deficiency beginning on the date the return was due and continuing until the deficiency is paid. In addition, penalties and fines may be assessed in certain situations.
5. Poor Corporate Recordkeeping May Affect the Ability to Sell the Business. Another reason for keeping accurate and complete corporate minutes and accounting records is that potential purchasers of your business will examine these records to determine corporate performance, and poor record keeping can affect the purchase price.
We represent both buyers and sellers of businesses. When we represent a buyer we insist on examining the corporate minutes and accounting records. Often, we find them poorly maintained, or hastily prepared in anticipation of the sale. In that event, we may advise our clients to proceed with caution and to consider further investigation or possibly a price adjustment to reflect uncertainties in the business.
In conclusion, we hope this discussion has been instructive. We realize it is often easy to ignore this formality, although it is usually not a time-consuming matter. The consequences of failure to comply with the corporate formalities may far outweigh the modest effort to prepare this documentation.