Starting Up Smarter
One of the main reasons that entrepreneurs incorporate their businesses is to protect against personal liability. By incorporating, they insulate themselves from liability in the event that the business just doesn’t work out, or if there is a catastrophic loss that exceeds the business’ assets.
However, incorporating is just the first step. Those who are not sensitive to what it takes to maintain their personal liability and vigilant in protecting it can be in for a rude and costly awakening. More often than not, this awakening comes at the worst possible moment, when someone is seeking to assert claims beyond the company’s means and “pierce the corporate veil” so that they can reach the assets of the shareholders.
Courts will look at a variety of factors in determining whether to allow the veil to be pierced. These factors generally relate to whether the corporation was operated as an independent entity or as merely an extension, or alter ego, of the shareholders. Factors that courts will look at include:
A. Whether corporate formalities have been observed.
This is why it is critical for corporations to (1) hold annual meetings of shareholders and directors and document them with minutes that are maintained in the corporate minute book; (2) issue shares and maintain a stock ledger; (3) document with resolutions all corporate actions requiring Board or Shareholder approval; and (4) make all annual State filings and pay all corporate taxes.
B. Whether adequate capitalization has been maintained.
If you do not provide the company with adequate capital, this can be used as a factor in determining that the shareholders and the corporation have not operated independently. While the principle is easy to articulate, knowing what is adequate capitalization is not. Generally, the standard is not high, but it is something that every company must be aware of and address.
C. Whether funds or assets have been intermingled.
If shareholders do not clearly delineate what funds and assets are the company’s and what funds and assets are theirs personally, they can wind up losing their insulation from liability. The same is true when separate financial books and records are not maintained. Companies should maintain separate checking and other bank accounts, a list of property they own and documentation showing how they obtained each item.
D. Whether corporate identity is clearly delinated.
It is very important that all those who are dealing with the corporation are clearly put on notice that they are dealing with the corporation, as a separate entity. This means (1) using corporate letterhead for all correspondence; (2) featuring the corporate name on all invoices, purchase orders and other commercial documents; (3) having separate email addresses and phone numbers; (4) adding a corporate signature to each email or other electronic communication; (5) making sure that all agreements, notices, applications and other documents are signed in the name of the corporation; and (6) maintaining a separate corporate website.
“Piercing the corporate veil” can apply to LLC’s, to corporations that are under joint ownership and to parent subsidiary corporations. In each instance, what is important is to make sure that the business entity that you are seeking to establish limited liability for is operated as a separate and distinct entity in all material respects.