I have many small business clients who incorporate or set-up an LLC under the premise that by doing so their personal assets are totally protected from creditors or liabilities incurred by the company and that is not an accurate assumption. Often, when someone makes this claim, it’s usually followed by the sentence, “I don’t know; my accountant told me so.” That is why accountants should manage finances and leave legal matters to lawyers.
Small businesses are often lazy when it comes to operating as a true corporation and that is where they can get into trouble. Now, by small businesses, I don’t necessarily mean small in size (i.e. – only 2-5 employees), but small businesses can also generate million dollar revenue streams and have a dozen employees but only one shareholder. This is what leads creditors and other potential litigants to believe the company and shareholder/owner are one and the same.
In order for a creditor to attach your personal assets to collect on a business judgment, when you are incorporated or operating an LLC, they would have to “pierce the corporate veil” and prove to the court that the company is your alter ego, which is a theory that was borne of corporate law. it developed because a corporation has limited liability and it was developed as an equitable remedy to prevent shareholders from hiding behind the corporate veil to escape personal liability.
A litigant, however, cannot merely assert the theory but must meet a set of criteria to actually pierce the veil in order to come after your personal assets. They must prove: that the company was not adequately capitalized (funded); a lack of corporate assets, liabilities or income; personal use of corporate funds (shuttling funds back and forth between personal and business accounts); use of corporation for personal business or the absence of separate corporate business; lack of a legitimate business purpose; or perpetration of fraud by means of the corporate vehicle.
So, what’s a business owner to do? The short answer is – if it walks like a duck and quacks like a duck then a judge will see it as a duck. Treat your business as the professional entity it was established to be. My suggestions would be to fund the company with adequate start-up costs and if you are loaning the corporation money from your personal assets then have the company give you a promissory note; maintain a separate bank account for the business and ONLY use it for company income and expenses; maintain adequate corporate records (use your corporate kit and actually issue stocks – don’t let it just collect dust under your desk); designate a board of directors if you are a corporation and hold monthly or quarterly meetings to discuss your business plan and operation; if you are an LLC, the general or managing member should routinely report to the other members.
Now that I have worried the idea of corporate protection right out of you, know that courts do not allow anyone to just pierce the veil merely by making an assertion that a business owner is using the corporation to advance personal interests. However, the more seriously you take the management of your business entity, the more vigorously a court will examine the situation before allowing a business creditor to attach your personal assets to meet a corporate obligation.