Many business owners know to form a company of some sort whether it be an LLC, S-Corp, C-Corp or some other entity. Often times there are tax consequences for selecting one business form over another (contact your CPA!). However, the main benefit of forming an entity is the protection from personal liability. Many think, “I just have to file this paper with the secretary of state’s office and I am protected!” Or, I will just use a cheap online service (Hello LegalZoom). But such a thought is the furthest thing from the truth. The filing of the “piece of paper” is just the beginning.
Business owners are afforded protection from personal liability from corporate acts by forming the company initially. But there is more to running a business and continuing to keep the protection. You must think of personal liability protection as a shield. By filing your articles of organization or incorporation, you have formed a thin veil around personal liability. However, you must continue to act in order to increase the protection. Before getting too far into increasing protection, it’s important to see why we want to increase protection.
Piercing The Corporate Veil
Many have heard the term “piercing the corporate veil,” but what exactly is it? Piercing the corporate veil, or "veil piercing," is a doctrine by which courts will sometimes disregard a corporation as an entity separate from one or more of its members or shareholders. Veil piercing allows creditors of a corporation that does not have enough assets to pay its debts to reach the personal assets of one or more shareholders of the corporation. This doctrine can also apply to creditors in the instances of lawsuits and judgments against a company in which the company’s assets cannot satisfy the judgement against it. If a court pierces a company's corporate veil, the owners, shareholders, or members of a corporation or LLC can be held personally liable for corporate debts. This means creditors can go after the owners' home, bank account, investments, and other assets to satisfy the corporate debt.
So how are creditors and others able to pierce the corporate veil? There are three common instances that lead to the doctrine:
1. Failing to Maintain Separation between the Corporation and Owner
The purpose of forming a business entity is to create a new identity. In order to do this, business owners need to allow for separation between their actions and those of the business. When such separation fails to exist, corporations are considered an “alter ego” or “dummy corporation.” For clarity, the owner and the company are viewed as one in the same. If an alter-ego or dummy corporation exists, the corporate veil can be pierced.
2. Fraudulent Actions by the Owner
Courts are setup to also determine what is fair and just. Often when there is no satisfactory remedy at law, courts will do what is fair and just. However, if a business owner fails to treat others fairly, he or she will have to face the consequences of making the other party whole. Such remedies can include piercing the corporate veil.
3. Creating Unjust Cost
This concept is very similar and closely related to number two. However, it is specific to incurring debt without justification and ability. If a company owner takes out a large financial burden for the company without an ability to pay back the debt, a court could pierce the corporate veil to ensure payment. Such instances include those where business owners shift capital around to appear insolvent in order to avoid creditor claims.
Now, back to how to increase protection.
Steps to Help Ensure Protection
First, it is important to treat the company as the separate entity that it is. The initial actions are through corporate governance. Once the articles are filed, it is important to have the operating agreement or by-laws drafted, adopted, and signed. Additionally, the company should have a corporate book and update it yearly with minutes from an annual meeting. As for day-to- day operations, the business owners must:
Open a business checking account and not commingle funds;
Issue checks with the proper business name;
Maintain separate books and records; and
Execute company documents under your corporate title (eg. Member, President, Shareholder)
As for finances, it is important to keep the company adequately capitalized and in good financial health. The company should not seek loans and contracts for more than the company is capable of repaying. Recklessly borrowing and losing money are a quick way to have the corporate veil pierced. And lastly, business owners should always act ethically and morally when conducting business.
Each one of these negative occurrences is chipping away at your personal liability shield. Why take the risk. Create great business habits and increase the strength of your company’s shield. Run your business like a business, and one in which you are proud.