Many small business owners who operate under a corporation or LLC have heard of the term “piercing the corporate veil,” but very few have a complete understanding of its meaning and implications.
We set up entities for ‘protection’, but that protection is not automatic. We have to protect the corporate veil and maintain the company in certain ways.
The “corporate veil” is a term of art that describes the primary asset protection benefit of operating under a corporation or LLC; that is, that the owners of the entity (corporation or LLC) are not personally liable for the debts or liabilities of the entity.
In other words, a creditor or someone who would sue the entity is limited to recovering from the assets of that entity only, and cannot reach the owners personally, or that of any other entity.
Sadly, we have all heard of Bernie Madoff and the thousands of people that were affected by his business practices. Well, in that situation, many of those harmed ‘pierced the veil’ and sued him personally.
“Piercing the corporate veil” is the primary exception to the rule that the owners and officers are protected from the company’s operations. A creditor suing in court may argue that, irrespective of the existence of the entity, they (the creditor) should be entitled to recover the assets of the owners personally.
The creditor could argue that the owner or officer, Bernie Madoff for example, acted negligently or fraudulently and thus the creditor is able to pierce the veil. In other less egregious situations, a creditor could show that when the corporation is not maintained in a ‘separate’ fashion from the owners, the creditor should be allowed to sue the owners personally.
The factors that are considered by a court when deciding whether “piercing the corporate veil” is acceptable, vary from state to state. However, the important factors to consider include:
1. Inadequate Capitalization. The assets of the corporation are inadequate to reasonably cover prospective liabilities. An entity should not be incurring liabilities in the company which it cannot reasonably re-pay. For example, running the company into a big hole with a lot of debt without a reasonable or foreseeable plan to pay off the debt could ultimately backfire. The courts and judges aren’t stupid. If they think you are just running up debt, to ultimately ‘bankrupt’ the company, they could easily stick you ‘personally’ with the bill.
2. Commingling of Assets between the Entity and the Owners, or Among Different Entities. Each entity has a separate legal existence and this separation should include its assets. An asset of the entity, for example a company car, should not be used for personal activities, and should not be used for a different entity’s business without proper documentation (e.g. a lease). Keep separate checking accounts for each business and for you personally, and do not pay personal expenses out of business accounts, or the debts of one business entity out of another business entity’s account.
3. Failure to Properly Maintain Corporate Records, Minutes, and Status. Operating under a corporation is not the same thing as operating as a sole proprietorship, but instead requires adherence to corporate formalities which include the holding of annual meetings, preparation of minutes, resolutions, and following the rules as specified in the corporate documents. KKOS has a “Cleanup” service and/or “Company Maintenance Program” to assist you with these requirements.
4. Holding Out that an Individual is doing ‘business’ rather than the Entity. All contracts and business of the entity should be signed and entered into by the entity itself, and signatures by individuals should be made as the representative (i.e. President, CEO, Manager, etc.) of that entity. Individuals should not be entering into obligations in their own name without reference to the entity (unless a personal guaranty is intended). Advertisements, business cards, stationary, websites, oral statements to customers, etc. should be clear that the business is being operated under an entity with limited liability (i.e. Corp., Inc., LLC, etc.).
5. Diversion or Concentration of Assets in one Entity and Liabilities in Another. A close counterpart to #1 above, piercing the corporate veil has also been used when an old corporation with debts merely closes and transfers its assets to a new corporation, or if one entity is being used to accumulate assets, while another is being used to accumulate debts. Such manipulation of assets and debts could result in the new corporation being liable for the debts of the old corporation.
6. Not holding assets in the name of the Corporation/LLC. If you want the corporate veil to protect you when you own rental properties (especially when using an LLC), you better make sure the entity is on title to the property and NOT you personally. Otherwise stated, remember the entity owns the asset, not you! Confirm that the title, insurance policy, and property tax records, etc… reflect the entity as the owner. As an aside, don’t stress about the ‘due on sale clause’ with a mortgage. You are still personally liable for the mortgage and signed for it, but in practice the property can and should be transferred to an LLC when it is a rental property, so long as the underlying ownership doesn’t change.
Again, these factors are not exclusive, and courts generally apply a balancing test to determine whether, in any given situation, the unity and interest of the corporation and its owners are such that it would be inequitable to recognize their separate personalities.
It is important to keep these factors in mind when you do business so that you preserve that primary asset protection benefit of operating under an entity.
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.