Many businesses have taken the smart step to incorporate as a corporation or organize as a limited liability company (LLC). Both corporations and LLCs offer liability protections to their owners. Generally speaking, in both instances, liability is limited to an owner’s investment in the entity and creditors and judgment holders cannot reach personal assets. Great! Let’s keep it that way! Here are some quick and dirty takeaways for business owners on maintaining their liability protection:
- Don’t commit fraud. This one is straightforward and simple. If you use an entity to perpetrate fraud on a creditor, a court will likely be willing to disregard your liability protection.
- Don’t “grossly undercapitalize” the entity. In determining whether an entity is “grossly undercapitalized,” the courts look at the specific facts and circumstances of each case and a bright line rule has never really been articulated. Here’s your quick and dirty takeaway: if your entity takes on major new liabilities at a point when it knows it can’t even meet its current obligations, there is a risk that the individual shareholders will be on the hook for payment once the entity’s coffers have been depleted.
- Don’t mix identities. Only use the entity’s funds to pay the entity’s bills. Don’t use the entity’s funds like a personal piggybank to pay for owners’ personal expenses. In short, respect the entity’s separate identity and a court should too. While we’re on the subject, the same identity mixing rules apply to the entity and any related entities (i.e. parent, subsidiary, and other related companies).
- Do respect organizational formalities. Failure to meet organizational formalities is another factor a court will look to in piercing the corporate veil. So to protect yourself, simply adhere to the formalities required of your specific entity form (these differ for corporations and LLCs somewhat). Generally speaking, put people on notice that the business is operating as an entity, hold annual meetings, vote when necessary, pass resolutions, maintain bank accounts and other important financial records, and file all state required reports.