Business Operating Guidelines: Is this Pizza Run an Ordinary and Necessary Business Expense?
By Wayne A. Kinkade
Saalfeld Griggs PC
Growing up, before I got my big break and landed a summer job pulling “Green Chain” at a long-since closed saw mill, I spent my days pumping gas at a friend’s gas station (this was good work for a teenager down in Cottage Grove but $3.35 per hour didn’t pay for many books). Back then, I never gave it a second thought when the boss would swing by the station and grab $20 or $30 out of the cash register for his daily pizza run (especially when he returned with pizza for the crew). After all, he owned the station, so what difference did it make? Only later did I realize that this is exactly the type of “casual” bookkeeping that is frowned upon by business lawyers, courts and, in particular, the IRS.
Back when your business was formed, whether a corporation, a limited liability company, or another type of “limited liability” entity, you were advised that in order to retain the benefits of your chosen form of business entity, you would need to follow certain guidelines to ensure that the benefits remain available. Many of the issues discussed in this article do not apply to partnerships and sole proprietors because sole proprietors are not recognized as a separate entity for tax purposes and both partners and sole proprietors have “personal liability” for all company debts and obligations. However, if your business was formed to insulate owners from personal liability or to take advantage of certain tax strategies, the following are some issues that should be considered in day-to-day operations:
In order to retain limited liability for members or shareholders, it is critical that the company is operated as a business entity that is separate from its owners. If not operated as a separate entity, the existence of the company may be ignored by a court, and the owners may lose the protection of limited liability as a result. This so-called “piercing the corporate veil” occurs where a court allows claims against a company to be passed through to its owners. A favorite request of IRS auditors and opposing lawyers is to review corporate minute books and other records that evidence that such corporate formalities have been observed.
In order to function as a separate entity, an LLC or corporation must maintain sufficient assets to operate its business. For example, the company should not make substantial distributions of assets unless the company has earned profits from which to make the distributions. No distributions should be made if the effect of those distributions would be to render the company insolvent or prevent it from paying its obligations as they become due in the ordinary course of business.
As a separate entity, an LLC or corporation needs to have its own assets. The company must maintain its own bank accounts and should hold title to its assets in its own name. Under no circumstances should personal funds, assets, or accounts be mixed with company funds, assets, or accounts. Company funds should never be used to pay personal expenses of owners, to make personal investments for owners, or for any other purposes not related to company business.
Sorry, boss. The gas station should not be picking up the tab for your daily pizza run (surprisingly, my old boss has since sold the gas station and opened a pizza restaurant – eliminating any doubt as to his true passion).
The company should not transfer any of its cash or other assets to its owners except as reasonable compensation for services that have been agreed upon in advance, (such as reimbursement to owners for reasonable expenses incurred on behalf of the company), and as distributions allowed under the terms of the applicable operating agreement, bylaws or other governing company document.
If the company is to use assets owned by an owner, appropriate arrangements should be made and documented. For example, an owner can lease an office or piece of equipment to the company, but there must be a written lease agreement, and the terms should be fair to the company. Loans from owners should be documented with promissory notes and approved in company minutes.
The company should be operated as an entity that is separate from its owners. All business of the company should be conducted in the name of the company, and the company’s name should be used on all agreements, contracts, leases, orders, and other arrangements entered into by the company. This name should also be used on all products, signs, advertisements, correspondence, business cards, telephone directory listings, and similar items. The company must maintain and carry its own insurance and file its own income and employment tax returns. When an owner is acting for the company, as an officer, manager or otherwise, always remember that he or she is acting as an agent of the company and not in an individual capacity. For example, when signing documents, always sign under the appropriate company designation (i.e., as president, manager, etc.). Otherwise, the agent will increase the risk of incurring personal liability for the obligations of the company.
Corporations and LLCs are created and exist under state law. It is important that annual reports and other filings required by the state in which the company is organized be filed promptly and that all required fees be paid on a timely basis. If the company transacts business in a state other than the state in which it is organized, registration in the other state will likely be required. If such registration is required, it should be kept current and all required fees should be paid. Each year when the activities of the company are reviewed, or when information for annual income tax returns is prepared, it is a good idea to verify that annual information returns have been filed and fees have been paid.
INCOME TAX MATTERS
Beyond federal returns, the company may also be required to file income tax returns in states and localities in which it operates. For example, it may come as a surprise to some that business operations in Washington may be subject to Washington state taxes even if no offices are maintained in Washington and if only minimal contacts are maintained within the state. You should consult our office or your certified public accountant regarding compliance with applicable income and other tax filing requirements.
BYLAWS & OPERATING AGREEMENTS
The corporate bylaws or the LLC operating agreement provides a road map for conducting operations in a manner that preserves the benefits of these forms of doing business. We advise that you refer to the bylaws or operating agreement periodically to be certain that your company operations are being conducted properly. Among other things, you should hold a director, shareholder or member meeting, as applicable, whenever a decision requiring consent of directors, shareholders or members is to be made. A permanent written record should be made of all meetings that indicates who was present at the meeting, the action taken at the meeting, and the number of attendees voting in favor of or against matters coming before the meeting.
The issues outlined in this article are intended to act as a guide to maintaining appropriate operational formalities. If you have questions regarding these or other issues, please do not hesitate to contact us.