Every business in the country forms a corporate entity for several reasons. The first is so you can do business under the corporate name of your choice. Next and most importantly, someone forms a corporation to get what is called the corporate shield. Creating a separate entity for your business can protect the business owner from personal liability. I say “can” protect the business owner because, if you don’t follow the required formalities of a company, then you can lose the corporate shield. You should know what these formalities are, and you should follow them. If you don’t, you should know the consequences because they can be severe.
Certain mistakes and errors while operating your business could result in creditors and other parties piercing the corporate shield to attack the owner’s personal assets. That is why it is also called the corporate veil. “Piercing the corporate veil” is a legal phrase that describes the owners of a corporation losing the limited liability that having a corporation provides them. When this happens, the owner’s personal assets can be used to satisfy business debts and liabilities. This concept doesn’t apply only to corporations, however. Any business type that provides limited liability to its owners is at risk of piercing the corporate veil if the owners don’t take the steps necessary to ensure this protection remains intact.
Maintaining the corporate shield begins with keeping accurate books and corporate records. Also, it is essential to maintain corporate formalities, including the procedures in the operating agreement, bylaws, and other corporate documents. The abuse or failure to maintain corporate formalities could be a factor used to pierce the corporate veil. Instead of being a separate legal entity, it appears as if the corporation was set up for solely personal liability protection. In other words, you must act like a company to get and maintain the protection of the corporate shield.
Mixing business and personal assets is another mistake business owners make. You must keep the assets separate. For example, you should never use your personal bank account to pay business debts. Likewise, do not use a business bank account to pay your business debts or purchase personal items. When the assets are mixed, the court might find that the business and the owner are not genuinely separate entities. The time you invest in maintaining your corporate veil could prevent you from being personally liable for company debts and obligations.
A checklist for maintaining the corporate veil should include, but might not be limited to the following:
- Maintain separate accounts and finances (never commingle funds).
- Always sign company documents in your capacity as an officer or manager.
- Prepare and file all required documents.
- Hold annual meetings of shareholders or members to elect directors and officers.
- Maintain company minutes and records.
- Update and maintain organizational documents, including the stock/ownership register, bylaws, articles of incorporation, banking resolutions, etc.
- Follow all state requirements for remaining in good standing as a business entity.
- Make the legal entity known by using LLC, Inc. Co., and LLP in branding, letterhead, legal documents, bank account, business cards, etc.
- Prevent fraud or wrongdoing by establishing policies and procedures for following all laws, regulations, and rules.
The time you invest in maintaining your corporate veil could prevent you from being personally liable for company debts and obligations. Furthermore, the steps to maintain the corporate veil make it more difficult for owners and employees to make mistakes that could lead to corporate liability. Even though corporate formalities may take time and effort, they are the backbone of maintaining the corporate veil once it is established.
Courts are fully aware that reliance on corporate protection is vital to the continued creation of risk capital and that the entire structure of American business would radically alter if businesspeople could not rely on protecting the corporate structure. For the court to ignore the structure, the claimant must usually demonstrate by a preponderance of the evidence that the owners failed to utilize the corporate structure properly in vital areas.
As a trial attorney, I put it this way: There is no better defense to an attempt to pierce the corporate veil than to walk in front of the jury box with a minute book in your hands showing 10 years of corporate minutes, to open up the book and show resolutions made five years before the debt was incurred, and to slam the book down on the table and invite the jury to read through the minutes in the jury room. Seems dramatic, but it will surely drive the point home.
To create the structure and then not keep excellent written minutes, fully executed, and placed in a formal minute book, is to give up a vital defense that may someday be greatly missed. Annual meetings of the board of directors and shareholders must occur, and any essential corporate decisions should also have a corporate meeting with full minutes.
The corporation must have its own bank accounts, its own tax returns, and any transfer between the owners and the corporation or any payments of any kind to the owners must be scrupulously accounted for. If the corporation pays sums to an owner, it is either income in terms of dividends or salary, or a loan, in which case a written promissory note should be created… and the loans repaid with legal interest. If the corporation pays an owner’s expenses, there must be a legitimate business purpose, or it must be declared as income to the owner and deductible by the corporation. All this is true whether the corporation is subchapter S, whether or not there is a single owner, single director, or single officer. Indeed, the more a single person controls all corporate activities, the more vital it is that the corporation scrupulously apply corporate formalities to avoid efforts to pierce the veil if things go wrong with creditors.
Remember, it is the smaller corporations that are usually the targets of attempts to pierce the veil. No one claims that Apple, Tesla, or Amazon is the “alter ego” of its president. Still, hundreds of cases plead precisely that each year in companies involving 1 to 10 shareholders. The more informal you seem, the more formal you must be. And the fairer you treat your creditors, the less danger exists that you will spend the tens of thousands necessary to defend attempts to ignore the corporate protection that you now rely upon.
A client once told me he felt foolish holding formal meetings with himself, making resolutions, and carefully executing the minutes as President and Secretary. My reply was obvious: You will feel much more foolish if the jury determines that the corporate veil you relied upon should be ignored.
The above illustrates the corporate formalities that should be observed, but they are not an exhaustive list. If you want additional information about the appropriate actions to preserve your corporate shield, please contact me or another attorney to discuss your situation. Before a problem occurs, most corporations can be “cleaned up.” If a problem arises before cleaning up, whether via governmental audit, lawsuit, or otherwise, then those are the times that you will wish you heeded my free advice. Don’t wait until it is too late to act.
