One of the primary advantages of incorporating your business is that the business owners are not held personally liable for the debts or liabilities of the entity. Now this ENTIRE TOPIC encompasses all entities, such as the C-Corporation, S-Corporation, Limited Liability Company (LLC), Limited Partnership (LP), Professional Corporation (PC), etc… All of these entities provide for the asset protection of a “Corporate Veil”.
The purpose of this Corporate Veil is to protect the investors, owners and officers from losing their ‘personal’ assets if something goes wrong in the business. However, there are limits to this protection. In fact, under some circumstances, you may have heard of a creditor piercing the “corporate veil” and reaching the assets of the business owner.
While the law may differ slightly from state to state, the five (5) most common ways in which a business owner can lose the protection of the corporate veil are as follows.
1. Acting Negligently in your duties as an officer, owner and/or employee– This is the public policy that prevents the owner from acting like an idiot and thinking they can stand behind the Corporate Veil and be protected in every possible situation.
EXAMPLES: Your driving your ‘company’ vehicle down the road drunk. You receive complaints from your tenant about a mold in the basement, or a faulty stair rail or balcony and do nothing to prevent it. You have ice built up on the sidewalk of your store and do nothing to eliminate the hazard with salt or ice melt. You don’t carry Workers Compensation on your employees or call them sub-contractors, when they really are acting as employees.
The above examples are instances wherein the corporate veil will likely provide you NO PROTECTION whatsoever and a creditor can come after your personal assets. Of course, these laws and standards will vary from state to state, but you get the point. Act responsibly in the performance of your duties as an owner and officer of the company and you’ll go a long way in protecting yourself from a creditor claiming ‘negligence’.
2. Alter Ego– This occurs when the entity ignores the corporate formalities such that it may be considered the “alter ego” of the business owners. Corporate formalities include the holding of annual meetings and the preparation of minutes documenting what was discussed and agreed to in the meeting. Corporate formalities also include treating corporate assets as the assets of the business owner (e.g., shopping for your personal groceries on the business account).
HOW TO AVOID IT: Hold annual meetings and prepare annual minutes outlining significant events or decisions made by the entity. Don’t pay for personal expenses with your business assets.
3. Inadequate Capitalization at the Time of Formation– This occurs when the entity is inadequately capitalized so that at the time of formation there are not enough funds to reasonably cover prospective liabilities. This also can happen when a business owner proactively incurs a debt or liability for the entity without providing enough capital to pay for the liability. The business owner cannot rely on the protection of the corporate veil as a way to avoid payment for the liability.
HOW TO AVOID IT: Don’t proactively incur liabilities for the company which it cannot reasonably re-pay.
4. Confusing your Customer or Vendor- This occurs when not using the company name on all contracts and marketing material. The public needs to know who they are doing business with. If you confuse the matter, you expose yourself personally.
HOW TO AVOID IT: Get in the habit of using the company name on everything business related. You need only sign as the designated officer or manager of the company. Indicate that on the documents.
5. Commingling Funds- This occurs when you use the company bank account for personal items. Remember the corporation isn’t your private piggy bank. There needs to be separation between the company’s financial operations and your personal financial affairs.
HOW TO AVOID IT: If you need to take out money from the entity, take a draw from the business account first and then pay for your personal expenses from your draw.
If you need help with this, please consider our Company Maintenance Program or a “Clean-up” of your current entity with our Para-legal team under the direction of Becky Lloyd. You can reach her at 888-801-0010 or [email protected].
Mark J. Kohler is a CPA, Attorney, Radio Show host and author of the new book “The Tax and Legal Playbook- Game Changing Solutions For Your Small Business Questions” and “What Your CPA Isn’t Telling You- Life Changing Tax Strategies”. He is also a partner at the law firm Kyler Kohler Ostermiller & Sorensen, LLP and the accounting firm K&E CPAs, LLP. For more information visit him at www.markjkohler.com.