I was about to write “…one of the primary advantages of incorporating your business is that business owners are not held personally liable for the debts or liabilities of the entity” when I stopped myself. Let’s be real; the whole freaking purpose of setting up a corporation is to establish the corporation as a SEPARATE LEGAL PERSON.
This means that business owners typically only stand to lose their investment in a business even if the company’s debts and liabilities are significantly more than the investment amount. In other words, creditors can only pursue the entity’s assets and cannot reach the assets of the business owner. That layer of protection which separates the entities liabilities from the business owner’s personal assets is commonly known as the “corporate veil”. Sure, there are other reasons, like living the “corporate lifestyle” and all those great tax deductions but (don’t tell your CPA I said so) the reality is that the tax reasons for incorporation are subordinate to the overarching asset protection.However, the courts (and the IRS for that matter) don’t give you all these perks for nothing…
Law students learn at law school orientation that merely incorporating a business is not enough for a shareholder to avoid personal liability for corporate debt. The corporation must respect the formalities of its form of business. Business owners that act unethically or fail to maintain common business formalities can have their corporate veil “pierced”, and thus be personally liable for their business’s debts.
In order to avoid personal liability in a lawsuit or IRS audit, shareholders must be able to prove that the corporation is a bona fide business entity – a real business and not just a shell created to avoid personal liability or evade taxes.
The most common ways in which a business owner can lose the protection of the corporate veil are as follows:
1. Failing to Maintain Separation between the Corporation and Owner – “Alter Ego”
Because corporations and their owners are supposed to act as separate legal persons, courts don’t approve when owners behave otherwise. If the owners fail to maintain this formal separation, then the corporation could be deemed an “alter-ego” of its owners. In other words, the owners fail to treat the company like an entity distinct from themselves. When this happens, the owners will be liable for the actions of their “alter-ego” corporation and lose the protection of limited liability. This is quite aptly considered by attorneys to be the “gotcha” moment because at this point, quite frankly at that point, “the jig is up”.
HOW TO AVOID IT:
- Make sure you have a managing document: either an operating agreement (LLC) or a shareholder agreement.
- Maintaining separate books and records
- Recording your actions when acting with an executive function on behalf of the business
- Holding appropriate board meetings and recording minutes
- Adopting company bylaws and ensuring officers and agents abide by them
- Ensuring corporate officers and directors actually perform their functions
2. 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.
3. 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.
4. 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. Make sure you ALWAYS:
- Using separate bank accounts for business funds and personal funds
- Only issuing checks with the proper business name
If you need help with this, please consider our Company Maintenance Program or a “Clean-up” of your current entity with our L.I.F.T. (Legal Insurance Financial Tax) Audit team. Please contact [email protected] for more information.