Springfield Business Journal Articles


Getting The Most Protection Out Of Your Entity

Last month, we discussed the various types of entities that are available for a business owner. This month, we’d like to focus on how to maximize the protection available to business owners who have selected an entity offering limited liability – primarily corporations and limited liability companies.

Owning and operating a business is not without its share of hazards. In an attempt to protect assets, most business owners elect to operate as some sort of entity – whether as a corporation or as a limited liability company. The general rule is that a shareholder or member cannot be held liable for the entity’s debts or obligations. That is, creditors can reach the entity’s assets, but once those assets are exhausted they usually can’t reach the personal assets of the owners or shareholders of the entity. However, in a worst-case scenario, don’t think that you can simply walk away from a mess without any personal liability. The general rule of no personal liability can be disregarded through “piercing the corporate veil.”

Piercing the corporate veil means that a court will impose liability on an individual for an entity’s liabilities when the entity has been operated as a dummy or sham. Or, as lawyers say, the veil of limited liability may be pierced where the entity is merely the alter ego or business conduit of another person or entity.

A recent case helps shed some light on this issue. In that case, a property owner contracted with a builder to construct improvements. The builder was a corporation. Although 100 percent owned by the wife, the corporation was actually operated by the husband. Unfortunately, the builder did his work so poorly that the entire structure had to be demolished. The court ultimately awarded the property owner a multi-million dollar judgment. The property owner, faced with the prospect of collecting that judgment against a corporation with no assets, sought to hold the builder’s president (but not shareholder) liable.

The court agreed. Yes, that’s right - a non-shareholder officer was held liable for the entire judgment. The court’s rationale was that although the wife was the sole shareholder, her involvement in the company was minimal. The husband, on the other hand, was solely responsible for running the corporation. In other words, the court found that the corporate structure was a sham.

Under what circumstances, then, can a court pierce the corporate veil? Entire books have been written on the topic, but it’s important that you know the basic concepts so that you can avoid personal liability. Two prongs must be met. First, a court will analyze whether there was “unity of interest and ownership.” Essentially, the court will determine whether separate personalities for the entity and individual(s) exist. A court will examine the following factors: (1) was the entity adequately capitalized, (2) was stock ever issued, (3) were “corporate” formalities observed (such as annual meetings), (4) were dividends or distributions ever paid, (5) was the entity insolvent, (6) did officers, managers and/or directors actually perform duties, (7) were records kept, (8) were individual and entity funds commingled, (9) were funds diverted from the entity at the expense of creditors, (10) were there arm’s length transactions between related entities, and (11) was the entity a mere façade for the dominant owner.

As a business owner or officer, these should be on your laundry list of things not to do. Failure to meet one of the elements doesn’t mean that personal liability will be imposed – instead it’s a totality of the circumstances test. Nonetheless, prudent business owners will want to review their operations to make sure they don’t run afoul of these guidelines.

Although we will be talking about joint business owners and how to best document those relationship in the future, another fertile ground for piercing the corporate veil involves single member limited liability companies. Often, individuals setting up those entities may use an operating agreement (the equivalent of corporate bylaws) designed for a multi-member LLC and which calls for meetings, special voting rules and a host of other procedures. Rarely, if ever, will the single member LLC owner follow such rules – but rules they are, and failure to follow them may well constitute failure to follow corporate formalities. Even if an attempt to pierce the veil on this basis is defeated, valuable resources in terms of time and money have been lost in the process.

The second prong analyzes whether refusing to pierce the corporate veil will sanction fraud or otherwise promote injustice. This is a somewhat amorphous test, and there’s no hard and fast rule. In the case described above, purported loans owed by the husband to the wife were paid by the corporation during the litigation process – resulting in an empty shell of a corporation. Moreover, once the litigation started, the husband and wife began other construction work under a newly formed corporation such that profits from those endeavors would not go to the “old” corporation. The court found this was sufficient evidence. In short, if it smells fishy a court will probably find that the second prong has been satisfied.

Another area of concern regarding this second prong involves thinly capitalized entities. Courts will often look at whether the entity’s capital was reasonable given the possible liabilities. Since most entities are founded on debt, this appears troubling at first blush. However, most courts will take into account whether your entity had insurance. For example, if you have $1,000,000.00 of liability insurance, a court may well see that you made that amount available to certain types of creditors.

Selecting and setting up your entity is only the first step. Failure to follow through on good intentions thereafter can cause real harm. The lessons are simple:

  • Form your entity correctly and keep it in good standing with the Secretary of State;
  • Adopt bylaws or an appropriate operating agreement;
  • Keep your entity’s books and records separate from yours, never commingle company and personal assets, and get a separate business credit card and checking account;
  • Properly document all major business decisions and hold your annual meeting if required; and
  • Follow prudent accounting procedures and don’t take actions with the intent to defraud creditors or to allow fraudulent activity.

These general principles, of course, aren’t exhaustive, so contact your legal counsel if you are at all worried. Better to be prepared now than to face the possibility of massive personal liability.

by Thomas C. Pavlik, Jr.
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