How can business owners be exposed to personal liability?

Once you’ve organized your business, you’re still not completely immune to personal liability. When courts hold individuals liable for the actions of the corporation, this is referred to in legal parlance as “piercing the corporate veil.” To avoid personal liability for the debts and other acts of the corporation (or LLC), you must manage your business entity as a truly distinct and separate entity from each owner’s personal affairs.

The corporate crest cannot simply be a facade with no real business purpose and the business must display characteristics resembling a real, ongoing business. In closely held corporations (very few shareholders), the same people tend to act in several different capacities, and this requires an effort to maintain those distinctions. Not to mention, small business owners naturally tend to treat all income as personal income and use business assets for personal use.

Courts normally examine whether there is “a unity of interest and ownership such that the separate personalities of the entity and the owner no longer exist and to maintain the distinction between the owner and the entity would be an injustice.” In other words, if the corporation or LLC is the alter ego of the individual and acknowledging the distinction would be unfair or fraudulent, the veil will be torn. It is impossible to describe everything that you must do to prevent the corporation or LLC from being seen as a mere extension of the owner. However, it is important enough that you should have a basic understanding of what you should and should not do to help protect yourself from personal liability.

A member of an LLC or shareholder of a corporation can be personally liable for many different types of claims, but they generally arise in these different scenarios:

1. Claims arising from an act or omission of the owner directly, such as negligence, fraud, illegal act, or breach of a fiduciary duty of the owner;

2. Claims arising out of a contract, particularly one that was personally guaranteed by the member;

3. Liability for unpaid employment taxes, wages, workers’ compensation insurance, and unemployment contributions;

4. Claims based on the concept of “lifting the veil” of the LLC;

5. Liability for consenting to or receiving a distribution in violation of the LLC operating agreement or applicable LLC statute.

These claims are not the result of choosing an LLC over a corporation, or vice versa. All of these exceptions apply equally to shareholders of corporations and members of LLCs. But, there are many exceptions to the limited liability rule. Many LLC members or shareholders will find that, because of the way the business is operated, the protection against promised liabilities and business claims is not significant.

Important factors used to pierce the veil

The courts will generally determine whether you, or the other owners, have carried on the business as a separate and distinct entity, and not as the ‘alter ego’ of the owners, as stated. But what actions or non-actions of the owners prove this in the eyes of the courts? State courts will look at all the separate facts and circumstances of each case to determine whether or not to lift the corporate veil. There are some common factors that show a court that your business was set up as a sham or an extension of yourself. Low capitalization, where it clearly shows, is an important factor. But, it is not an absolute reason to lift the corporate veil on its own without other factors.

These are the most common and key factors considered by courts in determining whether to lift the corporate veil:

1. If the corporation follows the corporate formalities (ie, create and follow the requirements and procedures set forth in the bylaws, keep minutes of shareholder and board of directors meetings, and create resolutions for major company actions);

2. Absence of corporate records;

3. Inadequate capitalization. The corporation is undercapitalized at the time transactions are entered with creditors or others who want the corporate veil lifted, or it simply does not have enough capitalization for the particular corporation to function). State laws govern the formation of a corporation. Inevitably, these laws establish amounts or formulas to determine the minimum amount of capitalization required for a corporation. You should check your state laws to determine the amount and make sure you meet the contribution minimums. Simply put, the lack of capitalization means that the corporation was never a viable entity because it did not have sufficient funds to support the debt obligations;

4. If the main shareholders are using the corporation’s money for their personal use (ie, when shareholders take money from the corporation to pay personal bills or buy gifts for themselves, etc.) or use other assets for personal use or gain;

5. Non-functioning of other officers or directors (having officers and directors who do nothing and were appointed by a majority shareholder, but who are not actively involved in the conduct of the corporation’s business and affairs);

6. Mix of funds and other assets between the major shareholders and the corporation (or LLC);

7. There are no corporate assets of any kind.;

8. Using the corporation to transfer responsibility from another (usually a shareholder);

9. Failure to issue shares and pay dividends;

10. Failure to keep records of expenses and gross receipts;

11. Contract with another without the intention of ever fulfilling the obligations;

12. Not maintain arm’s length transactions with third parties.

These are not the only factors that courts have considered, just some of the most common ones that you absolutely must follow at all times.

Piercing the corporate veil of LLCs

In general, a member or manager is not personally liable for the debts, obligations or liabilities of the LLC solely by virtue of being or acting as a member or manager. However, the concept of lifting the corporate veil applies to LLCs and courts can and have allowed LLC members to be personally liable in some cases. Some states, including Minnesota and Colorado, have adopted statutes that specifically apply the concept of piercing the corporate veil to LLCs. In other jurisdictions, such as Connecticut, Louisiana, Georgia, California, etc., it is the courts that have generally applied the concept of piercing the corporate veil to LLCs through case decisions.

Despite what you hear about LLCs, the Members will be personally liable if the LLC’s corporate veil is lifted by a shareholder-like court. Courts will apply the same general alter ego analysis used to pierce corporations, but sometimes without taking into account the lack of corporate formalities. While some corporate formalities are not required to be followed under the LLC’s organizational bylaws, this does not give LLC members carte blanche to operate as they please and avoid personal liability. For example, annual meetings are not required under most state LLC statutes nor are there detailed notice requirements for meetings and elections. However, certain corporate formalities common to both entities must be followed. Owners of an LLC that operates an Internet business should follow the same basic recommendations that corporations should follow.

Actions of an Owner as Director, Officer or Manager

The shareholders, officers, directors, and members of an LLC are always personally liable for their individual criminal acts. They are also always personally liable for their own direct acts or omissions that result in damage to persons or property (ie, torts), even when those acts were done in the course of the company’s business. For example, if you are an electrician and you leave a faulty wire exposed, the fact that you have formed an LLC will not protect you from this negligence.

Similarly, if you drive a company vehicle and insult someone on the way to a business meeting, You are still always personally responsible for their own personal actions. To the extent that you direct or authorize in your capacity as a director, officer or manager an action that is or results in a criminal act or causes damage to persons or property, you may be held personally liable. Any member who actively participates in the business of the LLC or corporation runs the risk that their action or inaction will result in personal liability. This is particularly a risk of a service business where members provide the key service. In the example I used above, if you are an electrician and you leave an exposed wire that electrocutes someone, your LLC will not protect you. The same is true if you are a shareholder.

If you make promises about your product or service that are not true, there may be a claim against the entity for breach of contract. However, if the LLC is unable to honor or pay damages, the injured party can sue you for fraud or a similar claim based on your own action. Even if you have an employee who did the deed, they may not be out of the woods. If you personally hired the employee, the injured party may bring a claim against you for negligent hiring if a reasonable person did not hire that employee.