It’s well known among entrepreneurs that incorporating (or forming an LLC) can protect their personal assets from the debts and liabilities associated with a business. However, for most entrepreneurs, the inquiry stops there. They believe that if they file with the state and pay their taxes on time, their personal assets will remain beyond the reach of creditors.
This is not necessarily true. To understand why, we must first examine the corporate shield for what it is and what it isn’t.
In a nutshell, in exchange for paying state business taxes, adhering to state corporate laws and keeping the state apprised of where you can be served with a lawsuit, the state allows business owners to keep their personal assets protected behind the corporate shield. The general idea is that the state has developed a set of regulations that it deems sufficiently protective of shareholders (or LLC members); if you agree to follow them, there’s a presumption that you’re operating your business in good faith and with sufficient independence.
Like any set of regulations, unscrupulous business owners have taken advantage of these protections in ways not intended by state governments, harming those with whom they do business. The most common abuse of the corporate shield occurs when business owners pay themselves an exorbitant salary, leaving the company depleted of the resources necessary to meet its financial obligations and debts. In instances like this, the court will sometimes pierce the corporate shield and allow a judgment holder to attach the assets of an individual owner(s).
The integrity of the corporate shield requires that a business be operated as a separate entity that adheres to corporate formalities rather than a mere extension of a business owner(s).
There are several grounds upon which a court can pierce the corporate shield, but they are not all equal. Like the example above, if a business owner keeps their business insufficiently capitalized (by removing the funds for personal benefit), a court is more likely to pierce the veil than it would be if a business owner failed to properly prepare minutes and resolutions (observing corporate formalities). That being said, courts will generally consider several factors in deciding whether to pierce the veil, including the following:
1. Insufficient capitalization
2. Fraudulent or wrongful business practices
3. Failure to operate the business as a separate entity (payment of personal bills out of a company bank account and vice versa; commingling of assets)
4. Failure to observe corporate formalities (failure to have annual shareholder/director meetings or sufficiently document approvals and minutes)
5. Comingling of assets between multiple companies owned by the same person(s)
The above isn’t an exhaustive list, but they are the key factors a court will consider when deciding whether to uphold the corporate shield. Business owners should not assume that just because their corporation is in good legal standing with the state that they can rely on the corporate shield. To do so, they should:
1. Keep personal and business assets separate: Avoid using personal credit cards for business expenses and vice versa. Keep bank accounts separate. If you have multiple businesses that do business with one another, document the transactions with written agreements.
2. Keep enough money in the company to pay its debts and liabilities: While there's no hardline rule for whether a business has sufficient capitalization, a general rule is to ensure you have enough to pay all ongoing liabilities such as rent, payroll, insurance premiums, taxes, state or federal filing fees and payments owed under vendor or independent contractor agreements.
3. Observe corporate formalities (or become an LLC in which this requirement is significantly lessened): Corporate formalities include preparing annual minutes, having required shareholder and director meetings and documenting decisions with appropriate resolutions if required by bylaws. If a business wants to avoid those formalities, forming an LLC can obviate the need for all of them.
4. Operate with transparency and in good faith: Never misrepresent your financial status to anyone with whom you do business, do not move money or assets around in an attempt to hide it from creditors or debtors and don't take any actions that could give rise to fraud allegations (fraud requires a misrepresentation, reliance and damages by the person relying on the misrepresentation).
The protection offered by the corporate shield is invaluable and should not be taken lightly. While it may seem to be as simple as filing articles of organization or incorporation, business owners cannot stop there. They should take care to treat their business as a separate entity with its own governance, banking and capitalization in order to guarantee the protection of their personal assets.
