Limiting one’s liability is a prime motivator for establishing a business entity, such as a corporation or limited liability company. Provided a business owner operates the limited liability entity properly and follows some basic formalities, chances are good that one’s personal assets will remain beyond the reach of creditors. Stated another way, creditors of the company can look only to the assets of the company to satisfy the obligations of the company. (This does not diminish the role of liability insurance, however. No business entity will shield your assets from your own negligent acts.) Owners of sole proprietorships and general partnerships do not receive such protection.
The term “piercing the corporate veil” means, in essence, that a creditor has successfully overcome an entity’s statutory liability protection, effectively rendering the owners’ personal assets in play. How can this be avoided?
Recognize the distinct nature of the corporate entity and adhere to simple formalities. Specifically:
• Do not commingle company assets with personal assets. The company checking account is not the owner’s personal piggy bank. Do not write company checks to pay for groceries. In fact, don’t even take the company car on vacation.
• Every transaction between the owners and the company must be documented clearly and in detail. This applies to loans, contributions and any other transaction.
• Owners must be certain that all transactions between them and the company are at arm’s length. No special deals like discounted pricing or interest rates: any transactions must be made as if the owners were dealing with an unrelated third party.
• Hold and document annual meetings of shareholders. In fact, document all meetings. See our article on the importance of documentation during the start-up phase.
• Whatever assets the company uses, the company should own. The company should not use the owner’s equipment unless it is purchased or leased in an arms-length transaction. If real estate is involved an attorney should be consulted.
• Owners should sign documents – such as leases, purchase orders…. any business transactions – in their representative capacity, such as president, manager, shareholder, etc. Without such designation, others may be led to believe one is engaging on a personal level and in a personal capacity.
We’ve seen business owners face the surprisingly unpleasant consequences when these basic rules are ignored. It is not difficult to institute best practices in keeping corporate formalities followed on a daily basis. Most attorneys are happy to provide quick, complimentary corporate audits to ensure their clients are on the right track.