Protect Your Liability Shield!

You set up your business and made sure that you have limited liability protection.  That means you do not have to worry about someone suing you personally for something that happened through your business, right?  Wrong!

Picture borrowed from the Indiana Business Law Blog

(www.michaelsmithlaw.com)

Plaintiffs will try to get around your liability shield through a legal concept known as "piercing the corporate veil." You will want to talk to a business attorney to get a thorough understanding of this, but this blog post will attempt to give you an overview.

Essentially, a plaintiff will attempt to sue you personally instead of suing your business by claiming that your business is really your "alter ego" and not truly its own separate entity.  This tactic is known as "piercing the corporate veil."  Courts will look at a number of different factors to determine whether or not to pierce the corporate veil and allow the plaintiff to proceed to sue a business owner personally.  These factors, and how they are interpreted, vary significantly from state to state as case law in each state continues to evolve.  Therefore, I would again like to emphasize that you should talk to a business attorney to make sure that you are operating your business in a way that will protect your liability shield under the state laws that your business is operating under.

One factor that courts will generally consider is whether the corporation or limited liability company (LLC) engaged in fraudulent behavior.  This should be common sense; you cannot expect to use your business to defraud others and then expect to escape personal civil liability just because it was done through a corporation or LLC.

Another major factor that courts will generally consider is whether the business followed the required formalities.  In California, this primarily applies to corporations because the formalities for LLCs tend to be relaxed.  As I mentioned in a prior post, What is a Corporation?, these formalities generally include, but are not limited to:

• Filing Articles of Incorporation with the California Secretary of State;
• Electing a Board of Directors;
• Enacting Corporate Bylaws;
• Holding Board meetings at least once a year;
• Holding shareholder meetings at least once a year;
• Maintaining separate bank accounts for the corporation; and
• Maintaining corporate records.

The general concept is that if you want your business to be treated as a separate legal entity by others, then you have to treat it as a separate legal entity yourself.  That means that even if you are the sole shareholder in the corporation, you must hold a Board meeting at least once a year (and maintain minutes of the meeting) to make major decisions for the corporation.  It is not enough that you make the decision because you are not the corporation- the Board must be the one to make the decision (even if you are the only Board member).

Likewise, you must be sure to not commingle funds. Have a separate bank account for your business (corporation, S-corporation, or LLC), and only pay business expenses out of that bank account.  If you put all of your personal funds and business funds in the same bank account, it strongly indicates to a court that you do not consider your business to be its own separate entity.  Similarly, if you pay personal expenses out of your business bank account, such as your mortgage, it gives a court the impression that it is just another personal account.

Another major factor that courts will evaluate when determining whether to allow a plaintiff to pierce the corporate veil is whether the business is undercapitalized.  This means that when you are first contributing money to the new business it must be a reasonable amount.  For example, if you expect your business to have $5,000 of operational expenses a month, an initial capitalization of $1,000 does not appear to be reasonable.

Finally, a factor that will be considered is the amount of control you are able to exert over the business.  For example, if you are the sole owner of the business you are fully in control of the business, and it would be easier for a plaintiff to argue that the business is really just an extension of yourself, your "alter ego".  On the other hand, if you are one of 100 co-owners each owning 1% of the business, it would be very difficult for a plaintiff to argue that the business is your alter ego.

So, as you see forming an entity that has limited liability protection is great, but you must protect your liability shield.  That means you must maintain all the required formalities, including maintaining separate bank accounts and not commingling funds, and you must adequately capitalize your business.

I would strongly recommending talking to an attorney to determine what specifically your business will have to do to protect your liability shield.  If you would like a referral, please send me an e-mail.