One of the first things I go over with clients when setting up a new corporation or LLC is how to protect the limited liability nature of the entity.
What is limited liability?
Limited liability means that if something bad happens in the business or the business loses money, the owner’s personal assets are (usually) still protected. Ideally, this helps business owners take risks to grow their businesses that they wouldn’t otherwise take, because they know that their house isn’t going to be at risk if the business goes under.
The entity (corporation or LLC) is a whole separate person from the business owners. Think of it like a security guard between your personal assets and your business liabilities, preventing the business liabilities from getting to your personal assets. In return for this protection, the owner has to take certain steps to protect the security guard from being attacked (see below).
This is in contrast to sole proprietorships or general partnerships where there is no security guard. Business owners who don’t incorporate or form an LLC will remain personally responsible for all the business losses and liabilities. This is why businesses that have the potential for lots of liability are usually encouraged to form an entity of some sort.
“Piercing the corporate veil” is when a court pushes past the limited liability security guard of a corporation or LLC and holds the owners personally liable for business losses. Generally, two problems with the entity have to be present:
- The owner(s) of the business have ceased to treat the business as a separate person, so that the business and the owner(s) are now the same person; and
- The owner(s) have done something that causes harm to another person, and it would be unfair to let the owner(s) off the hook by protecting their limited liability.
In general, situations in which veil piercing might happen (given some sort of bad owner action) include the following:
- Owner didn’t put enough money/assets into the business to allow it to operate
- Owner treats the business bank account as his/her own, and pays personal debts and costs with business money
- Owner doesn’t adequately document personal withdrawals from the business
- Owner makes withdrawals from the business that prevent the business from carrying on as normal
- Owner doesn’t hold meetings if/when necessary and doesn’t document internal business decisions (LLCs and corporations have different requirements on meetings)
- Failure to file required tax returns
- Owner is a sole owner
How to Prevent Veil Piercing
In general, business owners will want to document their internal decision-making, hold meetings as required by law, the bylaws, or the operating agreement, and document personal deposits, withdrawals, and expenses charged to the business.
In addition, bank accounts are often where business owners slip up. Remember that a corporation or LLC is an entirely different person, so if you wouldn’t take money without asking from your best friend’s wallet, you shouldn’t take money without asking from your business either.
In practice, this means that the business should have its own bank account and credit cards, used only for business expenses. If you have a personal credit card that you prefer to use for points, then an expense report should be filled out and filed monthly with the company, and a check cut to you personally. A business check should never be sent directly to your personal credit card company to pay off your personal credit card.
Any questions about specific practices should be referred to your corporate counsel.
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