By now, you've accomplished the first phase of your business operation: setting up your corporation, whether in the form of a C Corp, S Corp, or LLC. The articles have been filed, the company agreements signed (i.e. bylaws or operating agreement), the bank accounts opened and the business licenses obtained. Congratulations!
Unfortunately, the set-up is the easiest part. To preserve your liability protection, your business must be considered an entity unto itself, separate and distinct from its owner--you! Every day, ambitious trial attorneys attempt to subvert the primary purpose of a separate legal entity, its shareholder's limited liability, by "piercing the corporate veil" and suing the owners of these entities in their individual capacity. This means that your risk is no longer just limited to the investment in your company but rather is expanded to your own personal and hard-earned assets such as your home, individual bank accounts and investments.
The term "piercing the corporate veil" is a term used by attorneys to mean that the plaintiff in a lawsuit "looks" through the legal structure of an entity to the owners running the company for legal and financial recourse. In other words, the defendant is no longer ABC Corp/LLC but Bob Jones, owner and operator of ABC Corp/LLC.2
So how does one protect himself from being the victim of enterprising, and sometimes unscrupulous, trial attorneys? While there is no single answer to that question, it's critical that you as the owner of your company treat your company as a separate and distinct entity. From my review of case law history, I've compiled a list of elements that courts use in evaluating whether a "piercing" is justified. Remember, however, this list is neither exhaustive nor fail-safe; rather, identification of the problem areas will hopefully help you take the necessary steps to minimize the risk of being sued in your personal capacity for acts committed in the course of operating your trade or business.
Perhaps the single most critical doctrine the courts use to pierce the corporate veil is the "alter ego" theory. Alter ego occurs when shareholders treat the assets of the corporation or LLC as their own, use corporate funds to pay their private debts, and fail to comply with corporate formalities such as holding meetings and conducting business by resolution.
It's essential that your business have its own checking account to pay bills or its own credit card to make company purchases. If you use your car in the business and as a write-off for tax purposes, make sure you document the amount of miles you use it during the course of the tax year. Likewise, if you use your computers or electronics for business (though I recommend keeping separate business and personal assets), keep time logs breaking down the hours used on the computer for business and personal purposes. If you continually run your personal expenses through your corporate checking account or if you do not produce written records of corporate activity for personal assets, the likelihood of a court using the alter ego theory increases greatly.
In addition, third parties that deal with you must know that you are operating as a corporation or an LLC. Thus, I strongly recommend that the title on your company letterhead, business cards and signage contain the words "Inc.," "LLC" or "Corp." (As a matter of California law, Limited Liability Companies must contain the words LLC, L.L.C. or Limited Liability Company in the name of the Company title). Furthermore, you should sign all company contracts and agreements as:
Steve Perry, Member/Officer, etc.
To the extent you are using your own company letterhead with the appropriate heading, signing with just your name and title should suffice.
Keeping corporate formalities is also important, particularly for C and S Corporations. State statutes require that these corporations hold annual meetings to elect directors. Moreover, meetings must be commenced and a vote is required when there is a fundamental change of corporate structure such as a consolidation or merger. During these meetings, minutes should be kept in writing, votes counted, directors elected, etc. Moreover, it's important that you comply with all requirements as stated in the bylaws and articles of incorporation. For example, if your bylaws require you to hold a meeting every time an officer or employee of your company is hired, don't forget to hold such meetings!
On the other hand, California's LLC statute doesn't require the shareholders to hold annual meetings. From a plain reading of the statute, the California legislature seemed less inclined to impose corporate formalities on the LLC than it did on a corporation. Nonetheless, the LLC statute is a relatively new creature in American jurisprudence, and I recommend that my client err on the cautious side by holding meetings to elect Members or Managers, and otherwise keep with corporate formalities.
Inadequate Capitalization at Time of Formation
It's important that the shareholder of a company put at risk of the business unencumbered capital reasonably adequate for its prospective liabilities. All that to say, the more a shareholder contributes by way of his own money, the more likely the company will be adequately capitalized.
The amount of initial money or property that constitutes adequate capitalization is anybody's guess but courts generally look to the concepts of "intent" and "fairness." In other words, was the company set up with the idea of defrauding its creditors? How long after the owner contributed capital to the company did the owner contract liability on behalf of the Company? Was the liability reasonable or grossly disproportionate to the amount of capital contributed? These are the types of questions the courts ask when looking at this element.
In addition, the courts compare the amount of money contributed to the nature and magnitude of the corporate undertaking. For example, if you formed a manufacturing company that produced expensive machinery and employed numerous workers, but only capitalized your company with a few thousand dollars, you might run afoul of the inadequate capitalization doctrine. On the other hand, paid-in capital of a few thousand dollars might very well be appropriate upon forming a small bookkeeping company.
Avoidance of Existing Obligations, Fraud or Evasion of Statutory Provisions
The corporate entity is ignored when it is necessary to prevent fraud or to prevent an individual shareholder from using the corporate entity to avoid his existing personal obligations. In other words, a shareholder can't set up a corporation without a valid business purpose. The mere fact, however, that an individual chooses to adopt the corporate form of business to avoid future liability is not, of itself, a reason to pierce the corporate veil.
In sum, all of these factors, alone or together, are used to pierce the corporate veil and hold the owners of the company personally liable, which could have disastrous consequences. I encourage you to take your ownership responsibilities seriously and treat your company as a separate and distinct entity. Use software or bookkeeping companies to keep track of your company's income and expense. Comply with all of the governmental reporting requirements with respect to payroll, sales and income tax. And most importantly, seek legal counsel if you are confused or unsure about whether you are in compliance with the elements discussed above!
1 David Jones is an attorney with his own law firm located in Brea, CA. Before venturing out on his own, David worked as an associate at Stradling Yocca Carlson & Rauth and Deloitte & Touche. Graduating with honors from Villanova, he also obtained a Masters in Tax at NYU School of Law and currently practices in the areas of tax, corporate and real estate law.
2 This primer is introductory and basic in nature and not intended to serve as specific guidance on how to avoid the pitfalls associated with unlimited personal liability in connection with one's trade or business. Every case is different and legal counsel should be obtained before making legal judgments regarding the application of the "piercing the corporate veil" doctrine.