Incorporation alone isn’t enough to protect your assets or prevent personal liability. As with everything, there are rules and exceptions.
It’s true that incorporation is mandatory for most businesses. In most circumstances, incorporation will create a complete barrier between your personal and business finances. Sometimes, however, mismanagement and neglect can cause that barrier to falter.
There is a legal theory called “piercing the corporate veil” that every business owner should understand.
The idea is that incorporation creates a veil that separates a business owner’s personal and corporate assets. If suit is filed against the corporation and there are inadequate business assets, then the plaintiff or creditor cannot usually reach through the veil to take the owner’s personal possessions or money. The existence of a corporate veil is not absolute, however. It can be torn down in certain circumstances, thus exposing the owner personally.
So, an understanding of veil piercing can help avoid significant — if not fatal — problems. Fixing deficiencies before they fester are relatively easy.
The most common argument in veil piercing is called the “alter ego” theory. The idea here is that the veil should be pierced because the corporation is merely a sham and is an alter ego of the owner. A court will consider whether: (1) the owner or officers followed corporate formalities, such as holding board meetings, using the corporate name properly, and doing business in the name of the corporation instead of the owner; (2) solvency of the corporation; (3) siphoning of funds from the corporation; (4) a lack of corporate records; (5) whether it would be unjust to not pierce the veil of a corporation.
Assume that a small carpentry business incorporates. The company business cards have the owner’s name on them — not the business. Some of the invoices and letters are in the owner’s name, others use the company name. The owner has only one bank account, and he pays personal debts from the same account that he pays business obligations — and the balance is always hovering near zero. In fact, the owner uses money from the business to pay his debts before he pays the business debts. The business is not well insured.
Under those facts, can the owner be held personally liable if a customer sues for shoddy work?
I’d say it is likely the owner would be individually liable. Under those facts, it’s hard to tell whether a customer is dealing with the business or the the owner as an individual. The owner doesn’t consistently use the corporate name. The payments go to him directly. It would also be just to go after the owner as an individual if the business was devoid of assets (because the owner spent them on himself) and a harmed customer couldn’t recover against the company.
This is a pretty straightforward example (that actually isn’t uncommon). But what if the business is in compliance with some rules, but not others? What will happen if suit is filed, the owners are named individually, and proof has to be made in support of keeping the veil intact?
Indeed, this could turn in to an expensive mess.
Here are some guidelines to follow:
First, use your business name on everything. Everything. Business cards, flyers, invoices, checks — you name it. If you don’t have a fictitious name registered, use the actual name with the corporate designation, e.g., Home Repairs, LLC. If you are an owner, make sure you don’t sign for anything under your name. Make sure the word “By:” is above your signature line. Get an Internet domain that features your company’s name and create a simple corporate web site. Don’t use personal email addresses.
Second, keep your business and personal expenses separate. Once you receive your incorporation documents, go to your local bank and open an account. You will need the actual documentation due to restrictions under the Patriot Act. If you need money from that account, write a check to yourself or do a transfer with a description in the ledger.
Third, do everything possible to communicate your corporate name to your customers. This includes having a web site, vehicle lettering, and a separate business address. This way, there should be no question in anyone’s mind that they are dealing with a business and not an individual.
Finally, do your best to be “adequately capitalized.” Maintain adequate insurance levels (it’s fairly inexpensive to do so), and put money aside in a savings account. I know this can be difficult, especially when times are lean. However, do your best and make your best effort.
Doing all of the above cannot protect you from being sued as an individual. Anybody can sue anyone for anything. Ensuring that corporate formalities are maintained can allow you and your attorney to make short work of any such bogus claims. As with any defense strategy, the stronger your evidence, the less money (usually) you have to spend.
Veil piercing is an extraordinary measure and it is something that courts are loathe to do. But it does happen and it’s easily preventable if you follow the rules.