Liability can be quite confusing to a small business. Do you know what you are personally liable for? What are the exceptions to liability? What is “piercing the corporate veil”? How can you protect yourself? Don’t get caught in the rain!
Generally, the owners, directors and employees of companies (i.e. corporations and limited liabilities companies, or LLC’s) are not directly or personally responsible for the debts, harms, liabilities or obligations of their companies.
Thank goodness, otherwise shareholders of some companies could find themselves in serious trouble if their stock price tanks or other problems occur within the company.
EXCEPTIONS TO THE RULE
Often times, owners or directors can become personally liable for a company obligation- by mistake!
However there are two (2) important exceptions to this general rule of liability; voluntary liability and “piercing the corporate veil”. The first exception is obvious: it’s when someone freely agrees to become liable or responsible for some debt or obligation of the company. You find this in the form of “personal guarantees,” especially for small companies without credit. Frequently, the owner (or owners) will volunteer to personally guarantee the company, especially for merchant accounts and leases. However voluntary liability can get dicey as owners or directors often become personally liable or responsible for some company obligation by mistake — simply because the contract they signed had their name on it as a party instead of the company name. In all cases, never sign a contract where an owner, director or other individual is a named party. Instead, the company should be the named party, and you sign as “an authorized representative” of the company.
PIERCING THE CORPORATE VEIL
The second exception to the general rule is “piercing the corporate veil.” This is a legal mechanism used by the courts to ‘pierce’ the veil of protection a corporation or LLC provides in certain circumstances where the courts deem these protections unfair or against public policy. Confusingly, there is no specific test or rule for determining when to use this mechanism. Instead, the courts look at the “totality of the circumstances” to determine whether:
- no real line of separation exists between the company and the individual or individuals,
- there is wrongful or fraudulent conduct, and
- holding only the company liable would be singularly unfair to the plaintiff.
BUT WHAT DOES THAT MEAN?
In looking at the “totality of the circumstances,” the courts look to a number of factors to help them determine whether it is appropriate to “pierce the corporate veil” and hold one or more individuals personally liable for the debts, harms, liabilities or obligations of their company. The most common factors courts look at (although they vary significantly from state to state) are as follows:
- Commingling. Commingling occurs when an owner intermingles or freely exchanges or uses company assets (whether money, bank accounts, facilities, inventory, employees or resources) as his or her own, or amongst other companies.
- Failing to Follow Corporate Formalities. Corporate formalities are defined by a company’s operating agreement (if a LLC) or ByLaws (if a corporation), and if the company isn’t run according to those documents, a court will find that corporate formalities were not followed. Furthermore, the failure to keep proper corporate records or bookkeeping may also lead to an presumption of a failure to follow corporate formalities.
- Committing Illegal, Fraudulent or Negligent Acts. Illegal, fraudulent or purposefully negligent company acts will usually expose the owners to personal liability.
- Undercapitalization. Undercapitalization is a circumstance where it is shown that a company was never provided with enough funds to operate properly, and was therefore not really a separate entity that could stand on its own accord. Such undercapitalized companies are seen as a means to shield an owner’s other company (or companies) from debts.
- Failure to Maintain Arm’s Length Transactions. This often occurs when an owner maintains multiple entities (called related entities due to common ownership) and then conducts transactions between those entities in a manner one would not expect to see if the entities were not related. For example, exchanging products, services or other assets from one entity to another at below Fair Market Value.
- Acting as an Alter Ego. The “alter ego theory” is often used when it appears the corporation being used as a facade for the dominant owner’s personal dealings.
HOW TO ENSURE COMPLIANCE
As a general rule, every business owner should follow these common-sense tips to avoid a “piercing the corporate veil” issue at their company:
How can you make sure that your business follows the rules?
First, to avoid commingling:
- Maintain separate bank accounts and merchant accounts for your business (or businesses).
- If you own more than one company, and those companies share assets (whether facilities, inventory, employees or resources), designate one primary company for any particular asset, and make sure the other companies pay their fair share and reimburse the primary company for its use of the assets.
- Don’t write personal checks for company expenses and visa-versa. If the company needs money, it’s okay to lend the company money by writing a personal check directly to the company, which is deposited in the company’s own bank account. Then, the company can use those funds to pay whatever is needed.
- Don’t siphon money from the company to pay for personal items. Talk to your accountant or CPA to determine what are legitimate business expenses that may be written off, and refrain from illegitimate expenses that cannot be deducted.
Second, to avoid failing to follow corporate formalities:
- Dust off your bylaws (if a C-Corp or S-Corp) or your operating agreement (if a LLC), and READ THEM! Make sure you are managing the business as it says. If you are not managing the company as you are required (i.e. especially for big, important decisions), either change the way you manage the company or have your bylaws or operating agreement rewritten.
- Make sure you conduct at least annual company meetings, and that you keep a record of your meetings. Make sure you document all your important decisions according to the requirements of your bylaws or operating agreement.
- See if you have a company binder that contains a record of all your meetings and important decisions. If you don’t have one, start one.
- Double-check the ownership of your company, and make sure ownership percentages or shares are properly recorded, as required in your bylaws or operating agreement.
Third, always think about arm’s length transactions:
- Don’t give discounts to related entities.
- If one company cannot afford to properly pay another company, establish a line-of-credit between the companies.
- Conduct a reasonable investigation to determine the fair market value of shared, exchanged or transferred assets.
Fourth, never use a company to engage in illegal, fraudulent, or reckless acts, and make sure everyone knows they are dealing with a corporation or LLC by conspicuously identifying the company status (i.e. using “Inc.” or “LLC”) on all company marketing and materials, including but not limited to letterhead, proposals, quotes, invoices, business cards, directory listings, advertisements, and all other forms of company communication. When signing contracts on behalf of the company, clearly indicate your representative status by including your title (I.e. “John Doe, CEO, Doe Enterprises, LLC.”).
Fifth, if you are operating in other states, make sure you register your company as a “foreign corporation” or “foreign LLC,” as the case may be. Simply by selling online, you are not deemed as operating in other states. However, if you have a retail establishment, have employees, actively advertise and seek clients in a state, own real estate, or otherwise avail yourself in a particular state, you would be wise to register as a foreign entity.
Make sure you are getting your questions answered in the right places!
Finally, always consult with a good business attorney if you have questions or concerns about the liability protection your company provides. If you cannot find your bylaws or operating agreement, or know you don’t have them, now is the time (before you find yourself in an expensive lawsuit) to get them in place.
Law 4 Small Business. A little law now can save a lot later.