Piercing the Corporate Veil--Preventing Personal Liability
Most business owners choose to form corporations and limited liability companies (LLC) because of the liability protections they offer. By setting up a corporation or LLC, an owner is not personally responsible for the debts the business incurs, instead, the owner is only liable for the amount of capital they put into the business. However, there are certain situations where a court will hold a business owner, member, or shareholder personally liable for business debts. This is called “Piercing the Corporate Veil”. To prevent a court from Piercing the Corporate Veil and opening a business owner up to personal liabilities, a corporation or LLC must comply with the following rules.
No Co-Mingling of Personal Assets
Members of an LLC must follow business formalities to avoid liability
If a business owner fails to maintain a formal legal separation between her business and her personal financial affairs, then co-mingling occurs. To avoid this, the business owner should have a separate business checking account and keep strict accounting to differentiate between funds used for the business and funds used for personal purposes. This also means that the business owner should be careful in keeping an accounting, or log, of all assets that are used for the business and depreciate those assets if necessary.
Following Corporate Formalities
Business owners, members, and shareholders must follow corporate formalities. For corporations, this means the business must hold annual shareholder’s meetings and board of directors’ meetings. When an important corporate decision must be made, like opening a new bank account or entering into a new business venture, the business must hold a special meeting and give adequate notice of the meeting to all necessary participants. Detailed records and minutes must be kept for each of these meetings. Businesses must establish company bylaws and articles of incorporation. If members or shareholders fail to comply with any provision of these company documents, they may be exposed to personal liabilities. This usually occurs with smaller, family owned businesses which tend to have less resources and staff necessary to meet filing and compliance requirements.
Maintain Sufficient Capital
The business must maintain sufficient money and equipment necessary to start and continue business operations. This capital must be designated to the business and not to an individual owner of the business. Business owners will not be punished for an unsuccessful business model; however, courts will take a hard look at the company’s assets to determine if the level of assets available to creditors is fair. For instance, courts are skeptical of business that look like they are only used to pursue a hobby or recreational activity. The term “Hobby Loss” is used when a business uses funds to pursue a hobby or recreational activity and do not recoup those funds. An individual cannot start a business to receive tax benefits when the business is only used to pursue a personal hobby. That’s not to say business involving recreational activities or hobbies are prohibited; however the business must be generating an income and pay taxes on that income.
Maintaining Separate Identities of Companies
A court may pierce the corporate veil in a situation where multiple companies are acting under the umbrella of one company and fail to maintain separate identities for each company. If a parent company is operating and controlling a subsidiary company, providing all the necessary financing for the subsidiary, using the same officers and directors for the parent company and subsidiary, and uses the same address as the subsidiary.
Not Shielding Debts/Operating as a Sham
This occurs when a company was incorporated as a façade or a sham to escape prior legal obligations and debts. Most business owners who are starting a new venture do not need to worry about this if the business venture is legitimate. But if a company is set up to facilitate a large real estate transaction but only contributes one hundred dollars in capital, then that business would be be afforded liability protection from those debts. Similarly, if a business is sued but quickly dissolves and uses all its original assets to start an identical company under a different name, then a court would likely find that the business is just a facade to escape previous debts.
You have started a business but have not yet filed for an LLC or are unsure you if are following proper formalities, please reach out to us We’re business attorneys who are happy to help other business owners with the proper procedures for forming and maintaining companies.