Entrepreneurship is exhilarating. You get to provide the community with a valuable product or service—something that makes peoples’ lives easier, happier, or better. And best of all, the more value you provide, the more money you make. Talk about a win-win.
But entrepreneurship is also scary. It’s your money, your reputation, your project. To reduce the downside, business owners usually structure the company as a corporation or limited liability company. The reason is that these legal structures offer limited liability, meaning that they put a wall between a company’s debts and the people who own and operate the company.
Limited liability, however, is not absolute. Sometimes the people who own and operate the company can be held personally liable. LLCs and corporations with only a handful of shareholders are especially at risk. Whether that’s bad news or good depends on which side of the equation you are sitting on.
Knocking down the wall of limited liability is known as “piercing the corporate veil.” It happens under limited circumstances. Let’s discuss five common risk factors.
Fraud: Companies need to act forthrightly. If not, they lose many of their legal protections including limited liability. For example, if a company lies about its financial status to trick a lender into lending money, and then fails to repay the debt, the lender will often be able to reach into the pockets of both the company and the people involved in the fraud.
Commingling: A company and its owners should keep a clear barrier between their finances. The company should have its own bank account and funds. And the owners should have their own bank accounts and funds. The company should use its accounts and funds to pay for business expenses. And owners should use their personal accounts and funds to pay for personal expenses.
But in small businesses, owners and companies often treat personal and corporate funds as one and the same. They write a business check to pay for a personal mortgage. Or they cash a check payable to the business in a personal account. Doing either is known as commingling funds and is a recipe for having a court do just as the owner and the company did—treat both as being one and the same and thus equally responsible for the company’s debt.
Failing to follow corporate formalities: Companies need to follow certain procedures. Those procedures will vary depending on the type of company. For example, a corporation generally imposes more procedures than an LLC. But, in general, the procedures include keeping key company documents up to date, holding annual meetings for owners, and documenting major business actions. Corporations will also generally need to appoint officers and directors, hold regular board-of-director meetings, and maintain a stock ledger.
You may think these procedures and records sound excessive. Many small businesses would agree. And so, they don’t bother to appoint officers in writing, go years without a board meeting, and never hold an annual meeting. Skipping these things is fine during good times. But if the company loses a lawsuit or cannot pay its debt, owners are inviting creditors to try and pierce the corporate veil.
Not using the company’s name: Companies must act in their own name. They can do so by slathering their logo all over their website, stationery, business cards, and marketing material. And, of course, they should not only put their name on every contract but also disclose that the person signing on behalf of the company is doing so as a corporate representative. An easy way to disclose that fact is for the contract to list the company’s name followed by the representative’s name and business title (such as manager, vice president, or so on).
Medium- and large-sized businesses generally follow these steps as standard practice. But for smaller ones, like an accountant or real-estate broker, a customer may not know if they are doing business with a person or instead with a company created by the accountant or broker. To prevent confusion, the accountant and broker would be wise to use their company’s name during conversations and to have e-mail, invoices, and business cards showing the company’s logo and name.
Inadequate capitalization: When companies are formed, owners need to invest enough money for the company to pay for likely liabilities. Or they need to hold an insurance policy to cover these liabilities.
This situation often crops up when a company tries to insulate itself from debt by creating one or more subsidiary companies, all of which the parent company controls but does not adequately fund. The parent corporation then transfers debt into each subsidiary. When creditors come calling for the debt, they discover a shell company throwing up a liability shield between the debt and the parent company. Sometimes that shield blocks the creditor from collecting on the debt. Other times, a court will order the corporate veil pierced.
In sum, if you act honestly, follow basic procedures, adequately fund your corporation or LLC, keep business and personal accounts separate, and let the world know that they are dealing with a business, then it’s unlikely that you will be held personally liable for your company’s debts. If, however, you want to learn more about preserving or puncturing a company’s limited liability, consult with your attorney.
This column is not intended as legal advice. For anyone’s specific case, consult a lawyer.