Some people think that once a corporation or limited liability company (LLC) is formed, the individuals who own or manage these entities are completely protected from personal liability. This isn’t entirely true. Certain business actions can pop the bubble protecting these individuals, leaving them exposed in their personal capacity. This is called “piercing the corporate veil,” and you do not want that to happen to your business.
In general, a corporation or LLC is recognized as having a separate existence from its individual owners and officers. Consequently, the assets and liabilities are owned by the corporation or LLC itself and not by the individual owners. This means that a creditor usually can’t go after an individual shareholder or member/manager to satisfy a judgment against the entity.
In rare circumstances, a court will make an exception and issue an order to pierce the corporate veil. In Virginia, for example, the Supreme Court has held that such an order is an “extraordinary” remedy. It will be done only if the individual owner has “controlled or used the corporation to evade a personal obligation, to perpetuate fraud or a crime, to commit an injustice, or to gain an unfair advantage.” O’Hazza v. Executive Credit Corp, 246 VA 111, 115 (1993).
There is no one circumstance that will lead a court to pierce the corporate veil. Several factors are considered when determining if a corporation functions as an alter ego for its owners or was created to advance an individual’s private interest or commit fraud. These factors include:
- A Lack of Corporate Formalities – If a company/corporation fails to file annual reports with the state, pay annual dues, maintain minutes of meetings as required in its By-laws or Operating Agreement, or keep adequate corporate or financial records, this constitutes a failure to adhere to corporate formalities.
- Commingling of Assets – A court may find that personal and corporate assets were commingled if the company/corporation fails to keep a separate set of books and financial accounts, or if the owners of the company/corporation used corporate money to pay personal debts.
- Inadequate Capitalization/Corporate Assets – If a company/corporation is undercapitalized at the time of a transaction and when the creditor attempts to collect on the judgment, the court may order the corporate veil to be pierced. There is no threshold level that constitutes undercapitalization, but the courts will look at the debt-to-equity ratio and cash flow requirements.
- Insufficient Oversight by Officers and Directors – If the officers and directors of a company/corporation do not actually perform their duties as required by the Operating Agreement or By-laws, a court might find insufficient oversight. Also, if a solo owner uses the company/corporation to advance his own personal interests, a court might hold that the entity acted only as his “alter ego.”
- Fraud – A court may pierce the corporate veil if it finds that the company/corporation was formed to perpetuate a fraud, such as by moving assets from one entity to another.
While there is no exhaustive list for how to protect the limited liability of your company or corporation, the following is a list of basic “best” practices to maintain:
- Adhere to Corporate Formalities – Make sure that you pay your annual dues and adhere to the rules set forth in your By-laws or Operating Agreement. In the event you do not have these documents, familiarize yourself with rules set forth in the state corporations code, which will be applied to your company by default. Because these rules are applied to your company or corporation by default, it will likely be easier to use your own By-laws or Operating Agreement. Also, doing so demonstrates to a court that you respect the corporate structure.
- Keep Assets Separate – Set up a business bank account and make sure that personal debts are paid with personal funds and corporate debts are paid with corporate funds. Do not remove corporate funds to pay personal debts without signing loan documents or documenting the expense and the immediate reimbursement.
- Sign as Your Business – The limited liability of the company/corporation applies if contracts and documents are signed on behalf of the company/corporation. Make sure that you sign in your corporate capacity with the company/corporation and not as an individual.
- Do Not Mix Credit Cards – If some business expenses must be paid with a credit card, make sure that you have a dedicated card for business expenses.
- Maintain Adequate Corporate Records – Keep all of your corporate documents in one safe, secure place.
- Maintain Owner Accountability – Make sure that the owners and officers of your company/corporation are performing the duties set forth for them in the bylaws or operating agreement.
This is your business and your livelihood, so make sure you are cognizant of the actions necessary to protect yourself (and your assets). For more information relating to protecting the limited liability afforded to companies and corporations, contact Sarah Schauerte of Legal Meets Practical, LLC at [email protected].
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