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May 24 2016

Spring Cleaning for Closely Held Business Entities

By: Michael J. Huff

Spring is a common time for homeowners and businesses to engage in “spring cleaning,” tackling projects which acquire attention to better position the home or business for the long run.  It often behooves a business to review its legal documentation every few years as part of its “spring cleaning.”  Specifically, it is often beneficial to review the following documentation:

  •  Corporate Formation Documents
  •  Contracts, Leases and Notes with Related Parties
  •  Compliance and Record Retention Related Policies

Corporate Formation Documents

Corporate formation documents order the manner in which a business is structured to function.  The corporate formation documents organize the ownership and management of a business and often define the liabilities and obligations of shareholders, directors and officers.

Structurally, the vast majority of businesses in the United States are owned by small groups of investors.  Quite often, the same investors who fund the business also participate in the business as directors, managers and employees.  This structure can occasionally create challenges, especially in instances when passive investors help support the formation of a business, since directors and officers of a business owe fiduciary duties to the investors.  Unsurprisingly, disagreements can arise when the priorities of the passive investors in a business conflict with the priorities of the investors who are working in the business.

Across the United States, the law has developed considerably to address how investors govern the relationships between them.  Most notably, in recent years there has been explosive growth in the selection of limited liability companies (LLCs) as the corporate form of choice for businesses.  LLCs generally provide maximum flexibility to investors, requiring minimal corporate formalities and allowing investors to define much of their relationship by means of contract.

Since LLCs are a relatively recent corporate form, many businesses are still organized as a more traditional corporation.  Just because a company is structured as a corporation does not mean that there is no benefit to defining rights between investors, who in the corporate form are most often shareholders.  Quite often, in addition to the corporate bylaws, shareholder relationships will be governed by a separate shareholder agreement. 

Shareholder agreements are especially beneficial in closely held businesses, which are often called close corporations.  Since many of the shareholders in a close corporation will also work for the business, unanticipated disputes will often arise.  From time-to-time, these disputes will be of such a nature that they are unresolvable among the parties.  In such an instance, it is helpful for the parties to have defined a dispute resolution mechanism.  In most cases, a shareholder agreement will provide for the purchase of one party’s shares at a price which was predetermined by the parties in the event a dispute is truly unresolvable.  Resolving disputes in this manner often allows a company to continue as a going concern without incurring exorbitant legal fees.

Additionally, while fiduciary duties will still apply, it may be beneficial for those shareholders who provide services to a corporation to define how revenue will be divided as officers often want to receive payments in the form of salary whereas passive investors often prefer dividends.  Unsurprisingly, many disputes which arise often are rooted in matters related to compensation and contractually agreeing to certain distributions of revenue can help avoid future disputes.

In addition to shareholder agreements, it is worthwhile to review corporate formation documents such as articles of incorporation.  While the Michigan Business Corporation Act was updated over twenty five years ago to explicitly allow indemnification of officers and directors of a Michigan corporation except in certain circumstances, many corporations formed in the 1980s have not updated their formation documents to provide for the indemnification of directors and officers.

Contracts, Leases and Notes with Related Parties

Quite often, closely held business entities will have multiple legal and financial relationships with those parties who invest in the business and those individuals who manage the business.  Common relationships are loans between the investors and the company, the leasing of real property where the business operates from an investor of the company and contracts for services with related business entities which are owned or operated by investors and managers. 

Because of common control between some parties, many of the foregoing legal and financial relationships are not documented.  This is a dangerous mistake for a business.  Not only are such documents often necessary to produce to evidence business relationships when audited by the Internal Revenue Service (IRS), but in instances when litigation arises being able to produce valid agreements can often help to reduce liability by evidencing that such relationships were proper.  While it is tempting to let inter and intra party agreements be managed informally, from a liability standpoint a business entity is almost always better served properly documenting business relationships in the long run.

Compliance and Record Retention Related Policies

Even most closely held corporations are subject to certain state and federal regulations.  It has been prominently noted recently that barring an act of Congress, dramatic changes are coming to the minimum wage and overtime rules which govern many salaried employees.  Because changes in the law and applicable regulations occur on a regular basis, it is worthwhile for business entities to review their policies on a regular basis to assure compliance and minimize liability.

While there are many policies that should be reviewed on a regular basis, some of the most common questions directed to lawyers relate beyond employment related questions are related to how long certain records should be retained.  Developing and following a record retention program can help to minimize liability and cost by assuring documents are not destroyed prematurely or kept too long.

There are numerous considerations in regards to record retention.  First, documentation should often be kept for the applicable statute of limitations.  Even if a business entity believes it properly performed all services, an enterprising customer may sometimes look to bring a future claim.  Additionally, companies should retain documentation related to litigation, investigations and claims.  Beyond the foregoing, most business owners and managers are aware that financial documentation should generally be kept for at least seven years, so it is available in the case of an IRS audit.

Pragmatically, record retention is burdensome and expensive for business entities even in the digital age (in fact, the expense and burden is often greater given the ease with which documents can be generated).  Because of the expense and other considerations associated with record retention, it often makes sense to destroy certain records on a regular basis after the applicable retention period has passed.  Destroying records pursuant to a written policy may help shield a business entity from future liability, as well if a record subsequently becomes relevant in a matter but the business entity can demonstrate that destruction of the document was performed pursuant to a well-developed policy which included legal considerations rather than being destroyed spontaneously. 

Conclusion

Every investor and officer knows that managing a business is difficult and time consuming.  Often, assuring governing legal documents remain relevant to the business becomes challenging in the midst of managing the daily operations of a business.  Thus, engaging in “spring cleaning” on a regular basis and deliberately scheduling time to review legal documentation can benefit a company by assuring rights, obligations and liabilities are properly assigned, that such documents remain relevant to the business entity as currently structured and that the company’s policies have been updated to properly account for developments in the law.