How Can Business Owners Avoid Personal Liability for Corporate Debts?
A significant reason that business owners choose to form a corporation or limited liability company is because they are protected from personal liability. A corporation has a separate legal existence from the individuals who own it and from other legal entities. As a result, owners are normally not personally liable for the corporation’s debt. However, this protection is not absolute. Under certain circumstances, a plaintiff can ask a court to set aside the liability protections for a defendant company’s owners, an act known as “piercing the corporate veil.” This allows plaintiffs to collect damages from individual owners where the corporation has insufficient assets to pay the judgment.
When Are Business Owners Personally Liable?
Whether courts will pierce the corporate veil and hold owners personally liable can vary from case to case. Generally, piercing the corporate veil requires a showing that the owners exercised complete domination of the corporation in respect to the transaction attacked and that such domination was used to commit a fraud or wrong against the plaintiff which resulted in plaintiff’s injury.
There are no definitive rules governing when a company is under complete domination by the owners. However, there is certain conduct which is indicative of such domination. These instances include the following:
- Failure of the owners to adhere to corporate formalities;
- Inadequate capitalization of the business;
- Commingling of assets of the owners and the corporation;
- Owners’ use of corporate funds for personal use;
- No assets, liabilities, or income of the business;
- Overlap in ownership, officers, directors, and personnel;
- Receivables due to the corporation and commissions earned by the corporation paid directly to owners;
- Company is used for the transaction of the owners’ personal business, as distinct from the corporate business;
- Company has never transacted any business other than the acts at issue;
- Owners used the company as the means to commit fraud or perpetrate a wrong that caused injury; and
- Following the wrongful activity, the company has been stripped of its assets in anticipation of impending legal liability.
What Corporate Formalities Should Owners Follow?
Courts give considerable weight to the first action mentioned above – the failure of the owners to adhere to corporate formalities. These formalities include keeping up-to-date corporate books and records and holding regular meetings
Keeping up-to-date corporate books and records are particularly important as they may also serve as evidence relating to some of the other conduct mentioned above. For example, records can demonstrate whether there is overlap in ownership, officers, directors and personnel; whether the company is used for the transaction of the owner’s personal business as distinct from the corporate business; and the existence of assets, liabilities or income of the business.
What Best Practices Should Owners Follow to Avoid Personal Liability?
Owners can minimize the risk of personal liability by taking affirmative actions in how they operate the business. Important measures to take include the following:
- Hold annual meetings;
- Keep and maintain the required books and records, including:
- Minutes of the proceedings of its shareholders, board, and executive committee;
- The names and addresses of all shareholders;
- The number and class of shares held by each shareholder and the dates when they respectively became the owners of record thereof;
- Comply with company formalities set forth in the by-laws and/or limited liability company’s operating agreement;
- Document the clear separation of personal and business income and expenses;
- Avoid personal transactions in the company’s business accounts.
Furthermore, it is best practice to integrate a yearly evaluation of the above factors into the regular routines of corporation maintenance. As a prudent person gets a medical checkup once a year to maintain health and to avoid major health problems later, so should a company have a check-up on its corporate formalities, books, and records.
If you have not had a corporate check-up in the last year, now is the time. Contact us to help you avoid costly liability.