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The AR Group

Protection from Personal Liability – Business Entity Basics

By Julie Morris

One of the primary reasons business owners bother with the vagaries of learning about, guessing about, or simply selecting an entity formation is to protect themselves from downstream liability.? Whether structured as a corporation or a limited liability entity, such as a limited liability company or limited liability partnership, utilizing an entity structure has the potential to shield personal assets from those seeking to collect judgments or other debts against the business.

The Potential To Shield?

Business owners all too often mistakenly assume that once their business entity is registered with the state, they are free and clear of every and all business debt and liability. This is not the case. The hard truth is, business entities require regular and diligent attention in order to maintain an owner?s protection against potential liability.? All too often business owners neglect crucial ongoing obligations resulting in a piercing of the corporate veil.

Piercing the Corporate Veil

“Piercing the corporate veil” is a legal phrase that essentially describes how the law will treat or view the business entity when business owners have failed to appropriately distance the business entity from themselves. ?Essentially, the corporate entity will be ?disregarded? because the court will look at the manner in which the business owners treated the business (i.e., managed it or failed to manage it) and will conclude that it was insufficiently treated as an entity separate and apart from the individual owners such that it should be disregarded. As a result, the owners of the business entity lose the limited liability protection that was once provided. When this happens, the owners? personal assets may be used to satisfy business debts and liabilities.

Yes, ?piercing the corporate veil? can be a scary thought, particularly if you?ve never considered the possibility of losing liability protection. However, there are actions business owners can take to drastically reduce the possibility of such a loss. Thus, business owners would be wise to consider the following:

The Process?

Although the scenario can vary, the gist is this: The business owes a debt.? The debt is paid with the assets of the business but a balance is still outstanding. The creditor files a civil action to ?pierce the corporate veil? in an effort to satisfy the remainder of the debt from the business owners themselves. ?A Judge is required to make a determination, likely using the following factors:

1)???? whether the entity engaged in fraudulent or illegal behavior

2)??? whether the entity failed to follow corporate formalities

3)??? whether the entity engaged in a commingling of assets or the business was otherwise used as the individual owners? personal ? ? ? ?piggy bank

4)??? whether the entity was inadequately capitalized

5)??? whether the entity?s status was made known to others

The Factors

1)?? Illegal or Fraudulent Behavior: Not engaging in illegal activities is pretty straight forward. But financial fraud may not be as clear. Essentially, if an owner recklessly borrowed and mismanaged money, made deals knowing the business couldn’t pay invoices, or otherwise acted recklessly or dishonestly, a court could find financial fraud was perpetrated and limited liability protection shouldn’t apply.

2)?? Corporate Formalities: Business owners are required to conform to state-specific requirements; establishment of proper structure and procedures is also important. The most central document a business entity can have is that which contains the rules governing internal affairs. Whether in the form of corporate bylaws, an operating agreement, or partnership agreement, these rules dictate processes, obligations, and timelines business owners must adhere to. Failure to properly execute these rules or state-specific requirements can result in a loss of liability protection. Equally as important and perhaps more overlooked, particularly by small business entities, is the requirement that corporate formalities be maintained.? This means, for example, to the extent that annual notice requirements be sent, annual meetings and minutes be maintained, and records be kept.

3)?? Failure to Maintain a Separation of the Personal from the Business: Keeping business assets separate from personal assets can be overwhelming, however, it is critical that assets remain distinct and detailed records kept. If owners fail to maintain formal legal separation, a court could find that the business is really just an extension of the owners and equivalent to a ?sole-proprietorship.?

4)?? Inadequate Capitalization: If the business was never able to successfully operate because it did not have the funds to pay its day-to-day expenses, then a court could easily determine the business entity didn?t really exist, regarding it as a ?sham,? thus no liability protection.

5)?? Establishing a Known Entity: Business owners must make the status of the business entity known to any party involved in a transaction.? At a minimum, business owners should disclose the full, formal name of the business entity (i.e., include ?Inc.?, ?Corp.?, ?LLC?, ?Ltd.?, ?LLP?, etc.) on public-facing documents like marketing materials, business cards, and bids or proposals. Business owners must ensure that the entity is the actual party to any contract and that the individual owner only signs in an official capacity on behalf of the business; thus a signature block should start with the full formal name of the entity, have a ?By? line where the individual signs, and a ?Title? line or ?Its? line where the official capacity of the individual signing is disclosed. If owners fail to make it clear that they are acting on behalf of the business, it is reasonable for a court to find that the owners made personal guarantees and are personally liable.

 

Smart Tip: Business owners are encouraged to maximize the extent of their personal liability protection by: adequately capitalizing the entity in the first instance, following corporate formalities, maintaining a separation between the business and personal, not engaging in fraud or other illegal activity, and ensuring those with whom you interact understand that they are doing business with a corporation or other limited liability entity.