13 May Don’t Let Your Company’s Corporate Veil Be Pierced–Maintain Corporate Formalities

Recently, Edwards Law has been focusing on limited liability companies.  We’ve talked about why they are the best corporate entity to use for your business, how you form them, and what it means to “make your LLC bulletproof.”  We have also talked about how to draft your LLC’s operating agreement to protect your rental properties, and how to protect your LLC when a member of your LLC files for bankruptcy.  However there are other ways to protect your LLC from litigation and the “piercing” of your company’s “corporate veil”.  The easiest thing you can do as a business owner is to maintain corporate formalities.

What are Corporate Formalities?

Once you have formed your LLC, you must be sure to set up and maintain the corporate formalities of your business.  “Corporate formalities” refers to the actions you take as a business owner to make sure you operate your LLC as a distinct business entity, from yourself as an individual.  This is the only way you can ensure that you are not held personally liable for the debts and liabilities of your business.

How do you maintain corporate formalities?  You should do the following:

• Make sure that you are not commingling the funds and assets of your company with your own personal funds and assets. This is done through good bookkeeping practices, like keeping track of business income, expenses, etc. in a separate Excel spreadsheet (or paying a bookkeeper to do this for you) and opening a separate business bank account in your company’s name with your LLC’s EIN number and operating agreement.

• Make sure you maintain adequate corporate records. If you own a corporation, this means maintaining bylaws, maintaining meeting minutes, maintaining corporate meeting records and voting records, etc. If you own an LLC, this means at a minimum maintaining an updated operating agreement and documentation concerning member shares of the LLC.

In sum, make sure to set up the ownership structure of your company so as to minimize insider misuse and the appearance of impropriety.  When a court is looking at corporate formalities, it will consider the nature and form of your company’s ownership and control; whether your company is thinly capitalized; whether it appears that the company is being used by you as a “mere shell” to carry on improper activity; whether you are disregarding corporate or legal formalities; and whether you are using company funds or assets for non-company purposes (more below).

When Will the Corporate Veil Be “Pierced”?

A duly formed corporation or LLC is a legal entity distinct and separate from those individuals that own it.  This separate status normally insulates you as the business owner from personal liability for the debts of the corporation or LLC.  This is the inherent purpose of forming an LLC or corporation.  It is only in extraordinary circumstances that a court will disregard your company’s corporate status to impose personal liability on you as the owner.

For example, you as the business owner may be individually liable for the company’s actions when the corporation is “merely the alter ego” of you as the shareholder, and “the corporate structure is used to perpetuate a wrong.”

A company is the alter ego of its shareholder when it is a “mere instrumentality for the transaction of the shareholders’ own affairs, and there is such unity of interest in ownership that the separate personalities of the corporation and the owners no longer exist.”

To determine whether a company is an alter ego, courts consider the following factors:

• whether the corporation is operated as a distinct business entity
• whether funds and assets are commingled
• whether adequate corporate records are maintained
• whether the nature and form of the entity’s ownership and control facilitate misuse by an insider
• whether the business is thinly capitalized
• whether the corporation is used as a “mere shell”
• whether shareholders disregard legal formalities and
• whether corporate funds or assets are used for noncorporate purposes

If a court finds these elements are met, the court will then determine whether justice requires recognizing substance over the corporate form because “the corporate fiction was used to perpetrate a fraud or defeat a rightful claim”.  It is only when the corporate form is used to shield a dominant shareholder’s improprieties that the veil will be pierced.

The goal with maintaining corporate formalities is to keep the operation of your business separate from your personal finances so that you and your family are protected in the event of a business disaster.  Make sure you are starting off on the right track by talking to an attorney about forming your business and maintaining corporate formalities.  Call Edwards Law today.