Posts Tagged ‘commingling assets’

Personal Liability For Business Debt: The Protection Of A Corporation Is Not Automatic

June 16, 2014

pierce corporate veil

A key reason that business owners and shareholders choose to form a business as a corporation or limited liability company (LLC) is the protection from personal liability for business debt that is afforded those business types. Corporations and LLCs exist separately from their owners as do the assets and liabilities of those entities. But the protection from personal liability is not automatic. Business owners have a responsibility to show that the business operates independently from its owners. Failing to do so puts the owners at risk that a creditor may be able to disregard the company as a separate legal entity, and impose personal liability upon the entity’s owners, shareholders or members. This process of seeking to hold owners personally responsible for the debts of the business entity is known as “piercing the corporate veil.” When this happens, the owners’ personal assets can be used to satisfy business debts and liabilities. This means creditors can go after the owner’s home, bank account, investments, and other assets to satisfy the corporate debt. To ensure the protection of a corporation or LLC remains intact business processes must be in place to demonstrate the separation a business entity from its owners. At the inception of a business and then continuing during the life of a business, processes must be proactively managed to avoid situations which could cause the corporate veil to be pierced. Consider the most common factors courts use in determining whether to pierce the corporate veil:

Following Corporate Formalities:  Corporations have strict formalities they must follow, and while LLCs do not face the same requirements, many of the same steps are advisable. Small corporations are less likely than their larger counterparts to observe corporate formalities, which makes them more vulnerable to a piercing of their corporate veil. It’s important for small corporations and LLCs to comply with the rules governing formation and maintenance of a corporation and to maintain proof of compliance, as follows:

Corporations
• Create and regularly update bylaws
• Issue shares of stock to owners (shareholders) and maintain a stock transfer ledger
• Hold both an initial and then annual meetings of both directors and shareholders
• Undertake any annual filings required by the state of incorporation in a timely manner
• Pay the necessary filing fees and corporate taxes

LLCs
• Undertake any annual filings required by the state of incorporation in a timely manner
• Pay the necessary filing fees
• Create and regularly update an operating agreement
• Issue membership certificates to owners
• Keep a membership transfer ledger
• Hold both initial and then annual meetings of the members and managers
In both instances the organization must ensure that officers, agents, or members abide by the requirements of either the bylaws or operating agreement.

Ensuring Adequate Capitalization:  A business requires money and the equipment and items necessary both to start and continue operations. There are several sources of funds for business operations: capital contributions from business owners, investments from others and business loans. Whatever the approach, without adequate capital, a business will not survive. (Also keep in mind, this capital needs to be designated to the business and not the business owner.) There is no requirement that a corporation or LLC be flush with cash in order to preserve its limited liability, but it is necessary to have sufficient funds so that creditors are not left with uncollectible invoices due to a customer’s irresponsible overspending. Typically, courts recognize that cash flow problems can and do occur and will allow a creditor to pierce the corporate veil only if it is determined that the entity was “grossly undercapitalized” at the time the debt was incurred. This means that taking on significant debt at a time when a company can’t meet its current obligations puts it at risk that a creditor may be able to look to the individual shareholders for payment. Starting a large project or purchasing supplies or inventory with the knowledge that the business cannot pay the related debt increases the likelihood that a court will permit the company’s veil to be pierced.

Maintaining Separation Of Business And Personal Assets:   Small-business owners may be more likely than their larger counterparts to intermingle their personal assets with those of the corporation or LLC. Some small-business owners divert corporate assets for their own personal use by writing a check from the company account to make a payment on a personal obligation or by depositing a check made payable to the corporation into the owner’s personal bank account. This is called “commingling of assets.” A business owner may find it is easier to pay personal bills from a business account rather than write one check to cover the owner’s salary and then a second check from the owner’s account to pay a bill. Regularly following this practice could allow a creditor to pierce the corporate veil, particularly when the owner’s scheduled salary or draw is not enough to cover personal bills. To ensure that business and personal assets remain separate, the corporation should maintain its own bank account and the owner should never use the company account for personal use or deposit checks payable to the company in a personal account. Likewise, a business credit card should be used for business expenses only.

Inadequate processes are not the only reason the corporate veil may be pierced to satisfy a creditor’s claim. Business owners or shareholders may lose the insulation from personal liability for business debt if a court finds that the company’s actions were wrongful or fraudulent. If the owners recklessly borrowed and lost money, made business deals knowing the business couldn’t pay the invoices, or otherwise acted recklessly or dishonestly, a court could find financial fraud was perpetrated and that the limited liability protection shouldn’t apply.

C3 Advisors, LLC
June 16, 2014

C3 Advisors converges the three essential business elements—Process, People and Technology—to help businesses thrive, not just survive, by improving profitability and reducing risk. Our services help our clients improve process optimization, people integration and technology maximization.
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