Clients create entities (LLCs, LPs, Corporations, etc.) for a variety of reasons, including asset protection, starting a business, and consolidation of assets. For many clients, the entity has been out of sight and out of mind since its creation or initial funding, which may lead to a variety of issues.
Why does it matter?
The entity may be exposed to creditors or lose the ability to conduct business. When a client fails to engage in routine entity maintenance, creditors may have a better argument to “pierce the corporate veil” and access the client’s personal assets in a lawsuit. An entity may also become forfeited by the state, which means it loses legal authority to conduct business. In addition to fees and time needed to reinstate the entity, the client may face unnecessary delays if the entity attempts to enter into a transaction. We frequently see this occur when an inadvertently forfeited entity tries to sell its real property.
We recognize that clients may shy away from entity maintenance in fear of unneeded work or complexity. However, there are simple steps clients can take to maximize entity benefits…
Conducting Business in the Name of the Entity:
The client should conduct all business in the entity name as stated in the Certificate of Formation. The client should only deviate from the official entity name if an Assumed Name Certificate is filed with the state, which allows the client’s entity to operate under the Assumed Name. When signing on behalf of the entity, the client should sign in his or her official capacity as it relates to the entity, rather than in his or her individual capacity.
Managing Entity Assets and Accounts:
The existence and activities of the entity must remain distinct and separate from that of the client. The client should open a separate bank account for the entity upon its formation, and funds in the entity bank account should only be used for payments and expenses related to the entity. For example, if the entity owns a rental property, property taxes should be paid from the entity bank account and rental payments should be deposited directly into the entity bank account. Funds in the entity bank account should never be used for personal expenses. Additionally, funds in the client’s personal bank account should not be used to pay entity expenses, even if the client intends to reimburse an expenditure in the future.
Franchise Tax Filings:
For Texas entities, the Texas Comptroller of Public Accounts requires franchise tax reporting (the specific requirements vary based on the entity form). It is essential that the franchise reports are filed by the due date. Failure to submit required Comptroller filings results in late fees and eventually, forfeiture. Reinstatement is a two-step process that involves filings with the Comptroller and the Secretary of State. Most other states also have annual reporting requirements that, if not followed, can result in forfeiture.
Distributions:
Clients may want to make distributions of entity assets to themselves from time to time. This is certainly expected, but clients should be aware of two important issues that can arise. First, all distributions should be made pro rata to the owners. Otherwise, a non–pro rata distribution could require the adjusting of ownership percentages. Second, distributions should be made on a periodic basis, such as quarterly, when entity management determines there is excess cash on hand. Irregular or overly frequent distributions may provide creditors with an argument that the client disregarded entity formalities by treating the entity like a piggy bank.
Annual Meeting Minutes:
It is best practice, and may be required by the governing documents, to hold annual meetings to discuss routine business and make decisions. Topics that may be addressed during an annual meeting include management changes, membership changes, management fees, distributions, contributions, investment performance, revenue, and taxes. The meetings should be documented in Meeting Minutes, which can provide evidence that the entity observed proper formalities should the need arise.
It is essential that clients observe the ongoing entity formalities to ensure their entity continues to receive the benefits that led the client to set up the entity in the first place. We help a significant number of clients create entities, as well as assist them with their annual entity maintenance. We welcome the opportunity to help your clients with entity formation and maintenance. Please reach out to us if you have any questions regarding a client’s entity.
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