Learning how to protect your corporate or LLC veil is an important foundation for protecting your personal assets from your business. If you operate your business as a sole proprietorship and you are sued you may potentially lose all your personal assets. There is no separation between you personally and your business. This is the simplest form of business structure but has the least protection.
The next step is to form a corporation or LLC to separate your business from your personal assets. Now you have a separate corporate or LLC veil that provides this protection.
It’s essential to do things properly when you incorporate it is imperative that your corporation is treated as such. If the corporation is sued and there aren’t enough assets or insurance, the plaintiff may decide to go through the corporation and after you personally. This is called “piercing the corporate veil,” and the consequences to you can be devastating. This also means that it was proved that you were simply the “Alter Ego” to the corporation or LLC which means one in the same. You are essentially a sole proprietorship again, financially paralyzed, with a lawsuit against you personally!
How do you keep this from happening? Your new corporate or LLC MUST:
- Follow corporate formalities, keeping recorded minutes and resolutions;
- Have proper capitalization, which is the amount of money you put into the corporation to get it started;
- MUST NOT commingle funds with your personal account. Under no circumstances can you use corporate money to pay for your personal expenses.
Let’s take a closer look at how these three requirements can be breached or compromised:
- Lack of corporate formalities. Here’s an example: When an officer of the corporation goes on a business trip, the corporation must have a meeting to authorize that trip. This is hard for some to understand, especially if you’re a one-person corporation and you wear all the hats. Still, you must show in your corporate meeting minutes that the trip was approved because the corporation is NOT YOU. It must be treated as a separate legal entity.
Some people will tell you that an LLC doesn’t have to perform the same formalities as an S- or C-Corporation. (Actually, the main reason that CPAs sometimes recommend an LLC is because of lack of formalities.) While this is somewhat true, it is changing.
We’ve discovered recent court cases involving piercing the LLC veil where the judge looked at corporate cases for guidance, particularly with regard to formalities. Accordingly, the use of the term “piercing the corporate veil” has evolved to “piercing the entity veil” or “piercing the LLC veil.”
It is important to note that BOTH LLCs and corporations must maintain formalities. Some people seem to believe that an LLC does not have the same requirement for formalities as a corporation does. We have found in our research that court cases on this subject the judges will look to corporate law and cases when determining what standards to use with an LLC and guess what? The judges have determined time and time again that an LLC should look very similar to a corporation and have minutes and meetings. All our LLC record books have minutes and meetings and resolutions that match very closely to corporate formalities.
- Lack of proper capitalization: When you form a corporation, it has to be capitalized. That usually means money is put into a corporate checking account, and stock for the corporation is issued to whoever capitalized it (usually an individual, but it could be another entity.) There are certain guidelines in each state that ask, “Did you capitalize the corporation with enough money/assets, or was it too thinly capitalized?”
But what exactly is “too thinly capitalized?”
Lately, an unfortunate trend has been appearing in the courts. They’ve adopted a sort of “20/20 hindsight” in some situations, and companies in high-liability sectors like manufacturing are especially at risk.
For example, let’s say you’re a widget maker with five employees, and you’re capitalized -at $50,000 and have a $1 million insurance policy – which is appropriate because widgets are cheap and you don’t sell many. Then one day, Joe Employee cuts off a hand with the box slicer and saddles you with a $3 million lawsuit. The court says, “Mr. Business Owner, when you formed this company you should have known that Joe would slice off a hand someday, and you should have known that your insurance would cover only $1 million of the $3 million he’d want. Since you only have $50,000 in capitalization, we’re going to consider your company too thinly capitalized. Therefore, we’re going to allow the piercing of your corporate veil to recover the rest.” Crazy? Of course. But true.
Nevada, by the way, is one of the few states – if not the only one – that allows you to thinly capitalize the corporation, meaning as little as $100 is sufficient capitalization in Nevada.
You can capitalize a corporation or LLC with cash, assets, and, in most states, services. However, services can create a tax problem. For example, say your partner owns 50% of the corporation and capitalizes it with $25,000. You own the other half, and you capitalize it with services (called “sweat equity.”) The IRS says you received an asset without paying anything for it; therefore they treat that $25,000-worth of services as personal income to you. That means you have to claim $25,000 in personal income… but you never earned the money. What you did get was stock in a company, and now you have to pay taxes on it!
One solution might be for your partner to loan $24,000 and then have both partners capitalize the entity with $1,000 each. Just remember, the corporation has to pay back the $24,000 as a loan, whereas in the first case it was a capital investment that does not have to be paid back. This is a potential problem with partners when it is not clear whether the money is capitalization or a loan.
- Commingling of funds. As a sole proprietor, you no doubt have a company bank account. You can use that money for your business or personal expenses. At the end of the year, your CPA will help you determine which part of that money was deductible for business expenses, and which portion was for personal expenses. Often your CPA will find that you spent a lot of money on personal items that are not deductible business expenses. Still, the only consequence to you is that your net profit is higher than you thought, so you owe more in taxes than you expected.
It’s very different in a corporation. There must be a separate checking account used for business purposes only. Using that money for personal reasons is called “commingling of funds,” and the consequences are dire. A judge may actually set aside the corporate veil because you ignored the fact that the corporation is a separate legal entity from yourself – leaving you totally exposed.
The other most common way the corporate or LLC veil is pierced is for FRAUD. This could be as simple as forming an entity and then ensuing liability in the name of the company with no intention of repaying those liabilities. The business owner cannot rely on the protection of the corporate veil as a way to avoid paying for the liability.
The main principle here is that you cannot use the corporate veil to shield liabilities which you never intended on repaying. If ever litigated, the court may simply see the judgment creditor as being defrauded by the company.
- Gross negligence is another common way in which the Corporate Veil can be pierced and occurs when the business commits acts that are grossly negligent or reckless. Gross negligence occurs when the business intentionally fails to perform duties or commits reckless acts. Ordinary negligence can arise from simple inadvertence. However, ordinary negligence is not enough to pierce the Corporate Veil. In sum, if a plaintiff can show that the business committed reckless or crossly negligent acts then a court may allow a plaintiff or creditor to pierce the corporate veil.
Here are some other tips to protect your corporate or LLC veil:
1. Maintain an active status for your business entity with the states you are authorized to do business in. This usually requires a simple filing and payment of an annual fee to the State. Failing to stay current with the State will cause your entity to become in-active or delinquent and the state will assess you additional penalty fees for not meeting your annual deadlines. Moreover, if the entity is dissolved by the state, your protection ends on that date.
2. Own your business assets (e.g. real estate) in the name of the entity and execute all contracts and legal documents in the name of the entity. This may require new deeds or updates to contracts. Do not sign personally. You are signing on behalf of the corporation or LLC with your proper title.
3. Hold annual meetings and complete annual minutes. Plus, throughout the year as necessary.
4. Create letterhead and business cards for each business operation and use them. You want it to be clear that you are acting on behalf of your company and not in an individual capacity.
5. Maintain a separate checking account for each company and don’t co-mingle business assets with personal assets. Using your personal account for business activities shows a complete disregard for the Corporate Veil since you are not treating the company as a separate entity from the business owner.
6. Receive business income in the name of the business and pay for business expenses out of the business bank account(s).
7. Form a Nevada Corporation or LLC and foreign qualify or register in the state you are doing business. Nevada is the state of domicile. If your company is sued, it will most likely be in your home state. If the plaintiff (the person suing you) wants to go beyond the corporation (or LLC) and after you, the case will most likely go back to the state of domicile, which in this case is Nevada – where you get the most protection.
However, if you incorporate in a weaker state (without Nevada’s exceptional protections) and your veil is pierced… That’s right. You’re right back where you did not want to be. You can be held personally liable. You might lose the lawsuit – and you may lose your personal assets.
Even if you have formed a Nevada corporation or LLC, we still strongly recommend you follow all the tips and steps to protect the entity veil. You do not want to give anyone any ammunition that it may be easier to pierce the entity veil and go after your personal assets.