The primary benefit of using a corporate entity to conduct business is the limited liability protection afforded to its owners. Corporations, limited liability companies, and other such entities are recognized as legally distinct and separate from their owner(s). As a result, the owner’s personal assets are shielded from any liability for the entity’s debts. This principle applies equally whether in the context of a parent company using a subsidiary entity for a particular venture or in the case of an individual using an entity to operate a new business.
While business owners and entrepreneurs form a limited liability entity in order to operate the business, some fail to appreciate that simply forming the correct type of entity does not guaranty the liability shield on an ongoing basis.
In some circumstances, courts will ignore the limited liability separation and hold the owners accountable under a doctrine known as “piercing the corporate veil.” A successful veil piercing claim exposes the owner’s personal assets to liability for the entity’s debts. Plaintiffs often seek to pierce the corporate veil either with a view to ultimately expand the pool of assets available to satisfy a favorable judgment or simply in an attempt to increase leverage in settlement negotiations by introducing the specter of personal liability. The particular tests that courts use to analyze a veil piercing claim vary from jurisdiction to jurisdiction, but the fundamental inquiry determines the same – whether circumstances demonstrate that the owner(s) and the company are not truly separate and the corporate form should be disregarded.
Accordingly, it is essential that following formation of a company, owners and their corporate counsel ensure that the entity observes all corporate formalities in order to demonstrate its separateness and preserve the liability shield. These steps include:
- Adequate Capitalization. The entity should be adequately capitalized and insured at levels appropriate for its type of business. There is no minimum threshold of operating capital, but the parties should document the justification for the entity’s capital structure and allocation of debt and equity.
- Independent Operation. The entity should maintain separateness from its owner(s) at all times by using, as circumstances dictate, its own bank accounts, offices, telephone numbers, and corporate officers. Funds should not be co-mingled with assets of any other person or entity. Any financial interactions involving an owner should be formally documented and made on an arms-length basis.
- Governing Documents. The entity should have a formal written document (bylaws for corporations or an operating agreement for limited liability companies) that sets out the internal rules governing how the entity is operated and managed.
- Comply with Formalities. Once governing documents are adopted, the parties should then observe all procedures set out in the document(s). Board meetings should be held at the prescribed times and minutes should be kept of all meetings. All major decisions should be documented in resolutions or written consents adopted pursuant to the procedures established in the governing documents.
- Good Standing. The entity should be kept in good standing in its state of formation or incorporation and any jurisdiction in which the entity is registered in to do business by filing annual reports and paying any applicable franchise taxes when due.
These steps are illustrative of the corporate formalities that should be observed, but are not an exhaustive list. If you would like additional information about the appropriate actions to preserve limited liability protection, please contact the attorneys in Parker McCay’s Corporate Department at any time.
The content of this post is for informational purposes only and should not be construed as legal advice or legal opinion. You should consult a lawyer concerning your specific situation and any specific legal question you may have.