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Elizabeth O'Brien

Dangerous Corporate Practices That Can Lead to Personal Liability

04.30.12


Elizabeth O'Brien

It is a common practice for business owners to form either a corporation or a limited liability company in order to avoid personal liability for company debts. However the risk of personal liability does not end with the formation of a new entity. The business owner must continue to maintain certain "corporate formalities" (used synonymously in this article to apply to both corporations and limited liability companies) in order to remain insulated from the debts of the company. Failure to do so may lead a court to "pierce the corporate veil" and impose personal liability.  

A court may pierce the veil of a company when its owners have not treated the company as an entity separate and part from themselves. Here are the major factors courts consider:

  •  Failure to observe corporate formalities
  •  Undercapitalization
  •  Commingling of funds
  •  Diversion of corporate assets
  •  Failure to maintain arms length relationships among related entities

A.    Failure to Observe Corporate Formalities.

 Courts have frequently pierced the corporate veil when owners fail to observe basic corporate formalities. Your corporation should (a) maintain a corporate minute book, (b) hold an annual meeting of shareholders and at least occasional meetings of the Board of Directors, (c) prepare minutes from these meetings and keep them in the minute book, and (d) adopt resolutions reflecting approval of major decisions. Even if you are a one person corporation, some summary minutes should be prepared and kept in the corporate minute book. If you are operating as an LLC, an executed Operating Agreement is an essential document.

In addition, make sure your corporation has its own, separate identification – its own phone, fax and email and separate listings in any directories. Emails or faxes to an owner, officer or director should be sent to such persons at the corporation, not individually. All business transactions should be in the corporate name, on corporate letterhead, fax or email, on corporate checks, corporate bank accounts and corporate bills or invoices. A corporate designation such as “LLC” or “Inc” should be included.

B.      Undercapitalization.

Undercapitalization is another factor courts consider in determining whether a company is a mere alter ego of an individual, it is often a determining factor when other piercing concepts are present. Generally speaking, if the initial investment is insufficient to conduct the business, then the company is undercapitalized.   Courts have not set any hard and fast rule as to what dollar amount automatically meets the standard of adequate capitalization, but they have frequently held that a $1,000 initial investment is not sufficient. In one case, an initial investment of $5,000 and later advances of $29,000 were inadequate in light of the corporation’s average monthly expenses of over $10,000. A company should always provide adequate capital for the entity’s intended purposes and further, should document all capital infusion. 

C.        Commingling Funds.

A sure way to invite a lawsuit seeking to impose personal liability on the owners of a corporation is to commingle business and personal funds, or to use business funds to pay personal expenses of the owner. Examples of cases where courts disregarded the corporate status and impose personal liability include:

  • Funds were transferred from the business to the owners personal account but there was no documentation to show this was either salary or a dividend
     
  • The owner used corporate funds to pay alimony, child support, health care for a pet and educational expenses for his children

Of all the factors courts consider in deciding whether the corporation is merely a façade for the owners, commingling of funds and using business funds for personal expenses are the most serious.

D.     Arms-length transactions.

If a director, officer, or majority interest holder holds a majority interest or a decision-making role in other entities, every effort should be taken to keep all such entities separate and distinct. Courts will look to see if related entities are kept at “arms length”. In one case a company president honored obligations of one corporation from another corporation that he owned without any contract or duty to do so. The court concluded that the president as an individual was the sole connecting factor between these companies. In another case the court pierced the corporate veil when the owner used revenue and contacts obtained from a defunct entity to create a new company, in an attempt to leave a creditor with an uncollectible judgment. Companies should also be careful not to favor a related creditor.

Along the same lines, when dealing with multiple related entities, companies should avoid using the same or similar names, and should be sure to use separate letterhead, bank accounts, checks, telephone numbers, fax and email and even the same address (and employees, if at all possible). In one court decision, the defendant ran a number of companies from the same office, with the same phone lines and expense accounts for all the companies. In another case, the court pierced the corporate veil when two brothers who were the sole shareholders operated the corporations “as a giant cashbox with many drawers” adding or removing from the drawers “as desired”. Be sure that related identities are not blurred.

Protect your business and your personal assets by following some simple rules: keep company records, don’t co-mingle personal and business funds, don’t divert assets for personal use or for the use of related companies, maintain separate accounts, use company letterhead, business cards and checks for all company-related transactions, keep related entities at arms-length, and make a reasonable initial investment in your company. This is not only an important part of running your business, but crucial in estate planning and wealth preservation as well.