Maintaining your Corporate Protections

Now that you have established your separate business entity, you’ve created a shield, protecting your personal assets from business debts and liabilities. However, just creating the entity is not enough. You need to maintain certain standards and formalities. In this article, we will go into some of the basic steps you can take to maintain your corporate protections.

THE CORPORATE VEIL

Before we dive in, I will be using the term “corporate” throughout this piece. The term corporate, as used in this piece, is used as a shorthand to refer to both a corporation, LLC, or limited liability entity.

In corporate jurisprudence, there is a principle known as the corporate veil. The corporate veil is the conceptual barrier between the business owner and the business. If the corporate veil is maintained, negative actions against the business, such as unpaid debts, lawsuits, or fines, cannot attach themselves to the owner.

This is a very beneficial principle to business owners, and generally, the key reason that business owners incorporate or organize their separate business entities. This creates, however, a fairness problem.  If a business is unable to pay its creditors, and the creditor is not able to go after the business owner, we are effectively denying them full relief. To combat this, courts have establish certain circumstances, where a business owner’s conducts will allow the courts to “pierce the corporate veil”, finding that the business entity was merely a facade for the business owner, and hold the business owner accountable for the business liabilities.

PIERCING THE CORPORATE VEIL

There are a few circumstances in which the courts will pierce the corporate veil. The most easily avoidable is fraud. A court will not hesitate to hold the owners of a corporation liable for business debts where the owners have committed fraud.

Fraud aside, the specific rules and tests to determine if it is appropriate to pierce the corporate veil will depend on the particular state, but a key way to minimize your risk is to maintain corporate formalities. In our article on business entities, we described briefly the rules and restrictions governing the management and operation of the business entity. It is supremely important that small business owners follow these rules.

It is very easy for a closely held business entity to fail to follow corporate formalities. For example, let’s take a closely held corporation, looking to lease an additional location for their business. Under general corporate law, the president or CEO of the company would bring the decision to the board of directors, who would, in turn, would need to meet to discuss the prospect, and vote on whether to move forward with the lease. In some cases even, the shareholders may need to vote on whether to adopt the board of director’s decision. Only then, would the management of the corporation be authorized to sign the new lease.

In the case of a very small business, it may turn out that the CEO, board of directors, and sole shareholder is all the same person or close immediate family members. It would seem like a trivial matter then for the owner to just decide to expand the business and sign the lease. Why should the business owner take extra time holding corporate meetings and calling votes, when the decision is practically made already? While it may seem superfluous, business owners need to take care to maintain these formalities. This means that business owners need to maintain separate financial accounts and records. The business should not use its own funds to pay off the owner’s private debts. Business assets should not be used for personal reasons without compensation to the business. If a small business wants to avoid the liabilities of a sole proprietorship, the owner needs to make sure they are not operating as a sole proprietorship.

The other key step business owners can take is to keep the business responsibly and reasonably funded. Similar to the example above, in a closely held corporation, it may be a trivial thing for the corporation to pay excess profits to the shareholders as dividends. They may even follow all of the corporate formalities in order to do so. However, one of the courts most pressing concerns is fairness. The courts will not allow a business to pay its owners while simultaneously keeping itself cash poor in an attempt to avoid paying its debts. This does not mean that business owners are advised against taking dividends or draws from the company, but business owners must do so in a reasonable and responsible manner.

STICKING POINTS

·       Business entities are beneficial to business owners because the law regards them as separate from the owners

·       Business owners need to be responsible for maintaining that separation.

·       Business owners should not view their business entity as an extension of themselves.

·       Maintain separate accounts for yourself individually and your business.

·       Follow all corporate formalities, regardless of how silly it seems from a practical standpoint.