Five Ways Small Businessowners Can Protect Themselves from Personal Liability and Ensure the Corporate Veil is Strong

Five Ways Small Businessowners Can Protect Themselves from Personal Liability and Ensure the Corporate Veil is Strong

Pierce the Veil—It’s not just an emo-rock band touring with Blink 182 this year.  It’s a legal term of art that describes an equitable remedy used to bypass the corporate structure and hold business owners personally liable.

All right, let’s break that down.  That was a lot of legal speak, even for me (and I love legal speak).

Let’s use an example.

You are an aspiring small businessowner.  You do research, like a good aspiring businessowner, and realize incorporating your business (registering it with the secretary of state as an “inc.”) or organizing your business as limited liability company (registering it with the secretary of state as an “LLC”) means that if your business finds itself on the wrong end of a legal judgment, the plaintiff on the other side can’t reach past the company’s assets to take your personal assets.  It means that if something goes wrong, you won’t lose your home, your cars, or your family’s life savings.  Using an “inc.” or an “LLC,” done correctly, protects businessowners.

But if a court “pierces the veil” or “pierces the corporate veil,” this protection evaporates and allows the party that brought the legal claim to hold a business owner personally liable and recover any judgment from the business owner’s personal assets.

“Piercing the veil” is a type of “equitable” relief.  Usually in a lawsuit, litigants seek monetary relief—i.e., they ask the court to force the other side to pay money.  Sometimes, however, courts are asked to award other forms of relief. For instance, one may request that the court order an opposing party to halt certain actions or may request that the court compel certain actions.  Generally, relief that is not monetary is considered “equitable” relief.  “Piercing the veil” is a type of equitable relief: a party requests that the court disregard the legal entity (the “inc.” or “LLC”) and hold the business owner personally liable, including for any monetary judgment entered against the business.

To determine whether piercing the veil is appropriate, a Minnesota court will traditionally consider the following:

(1) Whether the business is “sufficiently capitalized” for the purpose of the corporate undertaking;
(2) Whether the business has paid dividends;
(3) Whether the business was insolvent at the time of the transaction at issue in the legal case;
(4) Whether one or more of the majority shareholders is siphoning business funds from the company for personal use or use in other, unrelated businesses;
(5) Whether there are any functioning officers and directors other than the owner;
(6) Whether any corporate records exist;
(7) Whether the corporation is being used as a mere façade to fund an owner’s personal expenses; and
(8) In the case of corporations (“inc.”), whether the corporation is observing corporate formalities.

After considering all of the above, the court will also consider whether not piercing the corporate veil will lead to an unjust result, or a fundamentally unfair result.

I know what you’re thinking—Ok, lawyer, but what am I, a businessowner, actually supposed to do to protect myself?

While there’s no magic bullet to avoid all risk of veil piercing, the following five action items for business owners can greatly reduce the risk:

1. As much as possible, do not use the corporate bank account or credit card to pay for personal expenses.

If there is only one action you take as a businessowner, let it be this:  Do not use your business account as your own personal piggybank.  Get a bank account for your business.  Get a credit card for your business that you pay-off using the bank account you’ve set up for your business.  Pay for business expenses with money from your business account or business credit card.

No matter how tempting it is, do not pay for your haircut, or your family vacation, or your mortgage with your business bank account or your business credit card.

Courts call this “co-mingling” funds and they hate it.

I get it—you’re a scrappy small businessowner.  You’ve poured every last cent into this business and have no personal assets left.  So, when your business account is in the black, you want to treat your hard-working self to that family vacation and use business assets to pay for the plane tickets and hotel.

STOP and back away slowly from this instinct.

Instead, pay yourself distributions from corporate profits—in other words, move the money from the business’s account to your personal account. This extra step formally identifies the money as a (taxable) payment from the business to yourself and is a way to move money across the legal wall between the business and yourself without damaging that wall.

Ideally, you should also be disciplined as to when, how, and how often you take distributions.  Best practice is likely something that functions like a weekly, bi-weekly, monthly, or quarterly wage. We realize that’s not always possible for business owners, especially small business owners, but if you can manage it, it will reduce your risk of a court piercing the veil.

2. Draft and maintain corporate documents.

The number of clients who come to us who are owners of multi-million-dollar businesses with no corporate documents is astounding.  If that’s you, you’re not alone.  Notwithstanding the good company you keep, we recommend that you don’t walk but run to get formal corporate documents in place.  These include operating agreements, bylaws, share certificates or ownership certificates, and stock or ownership registers. These could also include formal agreements between the corporate entity and any other entities that you’re conducting business with.  For example, if you have one entity that owns a building and a different entity that leases the building to operate out of, there should be a written lease agreement between the two. If there’s a loan from one entity to another, that loan should be documented in a written agreement.

It is, of course, best practice to work with an attorney to get these documents drafted.  However, if working with an attorney is not possible, there are examples of these documents available online.  While we don’t recommend a DIY on these types of documents, a DIY version is vastly preferable to no documents at all.  You may also consider hiring an attorney for the limited scope of looking over what you’ve drafted.

3. When possible, put in place functioning officers and a functioning board.

First, some definitions:

Officers are your c-suite folks—Chief Executive Officer (CEO), Chief Operating Officer (COO), Chief Financial Officer (CFO).  An LLC may use naming conventions such as President, Vice President, Treasurer, or Managing Member.

Directors, as in members of the Board of Directors, are individuals responsible for overseeing and advising the company so that it runs effectively.  The Board of Directors are also often responsible for holding the Officers accountable to the company and its shareholders.

Courts understand that not every business is big enough to support a full suite of executive officers or an entire Board of Directors.  Additionally, some closely-held companies (i.e., not publicly traded) simply do not want the additional layer of oversight a full C-suite or Board of Directors tends to impose, which can often slow-down decision-making.

However, a mistake we sometimes see is companies appointing CFOs, or COOs, or Vice Presidents in name only.  For example, if you are the sole-owner and CEO of your corporation and you name John Smith as your COO, but John Smith doesn’t actually have any ownership in the company and doesn’t actually have any authority to make any decisions regarding the operations of the company and, in fact, isn’t even asked to provide insight regarding the operations of the company, John Smith is not a functioning COO. If the company has non-functioning officers, a court may be tempted to question the reality of other features of the company, such as its corporate veil.

The moral of the story is if you appoint individuals to serve on your Board or as officers in your company, ensure that they are actually functioning in that role and not just filling out an empty spot on the org chart you pulled from Google.

4. If there is an operating agreement and/or bylaws, ensure the company is conforming to the requirements enumerated in those documents.

Remember those corporate documents we discussed in Action Item No. 2?  Those aren’t just fancy pieces of paper to be drafted and then shoved into a drawer.  Instead, the people responsible for the operations of the corporation should ensure that the procedures laid-out in those documents are followed and the obligations outlined therein are met.

Let’s take one of the most common procedures in an operating agreement as an example: an annual meeting of the shareholders.  Most operating agreements will require that the shareholders meet annually, and most operating agreements will explain the purpose of those annual meetings.  If your operating agreement requires shareholders to meet annually, ensure that (1) your shareholders meet once per year, AND (2) meeting minutes are recorded and saved somewhere to memorialize the meeting.  If an operating agreement requires an annual meeting for shareholders and you are the onlyshareholder, it’s still a good idea to set time aside once per year to make note of decisions your operating agreement requires you to make during the annual shareholder meeting and save those notes in a folder called “Annual Shareholder Meeting”.  (Another option would be to write into your operating agreement that no annual shareholder meeting is required if there are less than two shareholders.)  We know it seems silly, but taking this easy step can show a court that you take the existence of the company as a separate entity independent of your personal affairs seriously—and the corporate documents weren’t just created to check some sort of box.

Additionally, if the operating agreement requires an annual shareholder meeting unless a certain procedure is followed—say, unless the shareholders pass a resolution that no annual meeting is needed for that fiscal year—ensure that you follow the procedure to bypass the meeting and have written documentation showing that you took the proper procedure.

This can seem overwhelming. We understand.  That is why it’s generally best practice to hire an attorney to help you create the formal corporate documents. An attorney can work with you to conform the requirements in the corporate documents to your company’s operations rather than you trying to conform your company’s operations to the requirements in a template you found on the internet.

5. Get a good CPA.

This is a call-back to Action Item No. 1, above. Good CPA’s that work with closely-held businesses can assist with your books to ensure that all transactions flowing in and out of your business’s bank account are properly categorized on your company’s tax returns and to generally ensure that you are, indeed, not co-mingling your personal and business assets.

At Parker Daniels Kibort, we defend small businessowners from suits against their business and from attempts to pierce the veil.  Please contact us to review your corporate documents and make suggestions about how you can better protect yourself from personal liability in the event of a lawsuit. 612.355.4100.