Believe it or not, one of the greatest movie quotes of all time can relate to you and your business, and after reading this blog I hope you can use it as a simple reminder to help protect you from becoming personally liable for the liabilities of your business.
As you probably know, a corporation is treated as a separate entity that is distinct from its shareholders. As a general rule, the “corporate veil” protects the shareholders, directors and officers of a corporation with a shield from liability for corporate debts and other corporate obligations. From this principle flows the idea of limited liability; i.e., the shareholder and the corporation are treated separately, and the affairs and liabilities of the corporation ordinarily cannot be attributed to the shareholder. This concept of limited liability is a fundamental principal of corporate law and a principal purpose for having corporations. It is probably the reason that forming a corporation or other limited liability entity was one of the first steps you took when starting your business. However, just because you formed a corporation does not mean that the “corporate veil” providing limited liability cannot be “pierced” holding YOU personally liable for what are typically corporate obligations.
At this point, I expect that some of you don’t think this blog is applicable to you because you set up a limited liability company instead of a corporation. Not so fast my friend. To recapture the attention of those who formed LLCs, please be aware that Courts have recently begun to address the applicability of veil piercing to LLCs in the absence of express statutory provisions. In general, most Courts have concluded that some sort of veil piercing, usually corporate in nature, is applicable to LLCs. Now that you’ve tuned back in, let’s continue.
How do you know if you are at risk of facing personal liability for corporate obligations? As usual, it depends on the facts of your case and the tests and factors used by the Courts, which of course vary from state to state. However, in general, the following two factors must arise before most jurisdictions will pierce the corporate veil: (1) there must be such unity of interest and ownership that the separate personalities of the corporation and the owner no longer exists; and (2) circumstances must indicate that if the acts are treated as those of the corporation alone, it will sanction a fraud or promote injustice.
In Alabama, the courts consider the following factors when determining whether or not to disregard the corporate form and find personal liability: (1) inadequacy of capital; (2) whether there is a fraudulent purpose in the conception or operation of the business; and (3) whether the corporation is the alter ego of the person owning and controlling it, or is organized and controlled in such a manner to make it merely an instrumentality of another. Although these factors are considered, the final decision is a question of fact determined on a case by case basis. As a guideline, you should note the each of the following items have been used to help justify piercing the corporate veil:
The shareholders do not observe the corporate form
The legal requirements of corporate law are not complied with;
The corporation maintains no corporate records;
The corporation maintains no corporate bank account;
The corporation has no employees;
Personal funds and the corporation’s funds are intermingled;
Corporate funds are used for personal purposes; and
Individual drains funds from a corporation.
So, what can you do to avoid losing the protection of the “corporate veil?” Although not a comprehensive list, the corporation can help protect the limited liability of its shareholders by performing the appropriate corporate formalities, such as: (i) the preparation of corporate minutes for shareholder and director meetings; (ii) obtaining necessary licensing and other regulatory certifications to conduct business in applicable states; (iii) maintaining adequate capitalization and adequate insurance for its business; (iv) opening its own bank account; (v) doing business in its own name; and (vi) owning or leasing the property and equipment used to run its business operations in its own name.
As you probably know from reading our previous blog posts, the distinct separation of you personally from your business is critical to the appraisal, value, and marketability of your business. In addition, hopefully now you understand how critical this distinction can be for your personal protection, and how Michael Corleone’s famous quote can serve as a simple reminder to keep separate those items and transactions that are personal versus business in nature.
If you would like more information on business succession planning or any of the items described above, please feel free to contact any of Burr & Forman’s Business Planning and Succession team members.