A Look Into The Process Known As "piercing The Corporate Veil"
The number one reason to incorporate is to protect yourself from business debts
. The good news for entrepreneurs is that incorporating to avoid personal liability is a completely legitimate thing to do.
But that protection can be lost through a process known as "piercing the corporate veil" if the corporation isn't treated like a "real" corporation. If that happens, a court can pierce the corporate veil, thus allowing a creditor to recover from the principals personally debts incurred on behalf of the corporation, if the creditor shows, among other things, a "sufficient unity of interest and ownership that the separate personalities of the individual and the corporation no longer exist." Essentially this means that the business owners become personally liable for business debts even though they incorporated!
It all boils down to what happens after incorporating. Entrepreneurs run into trouble where they exercise "complete domination and control over the corporation." Figuring out whether the business owner had this sort of control over the corporation is based on the facts of the particular case, but over the years, courts in both California and New York have told us exactly what they are looking for:
-Commingling funds and other assets
-When the business owner treats corporate assets as his own (e.g., paying personal credit cards with corporate funds)
-Failing to issue stock
-The holding out by an individual that he is personally liable for the debts of the corporation;
-Failing to keep corporate minutes
-Inadequate capitalization
For a complete list of the types of things that courts look at, see Piercing the Corporate Veil - A Rare and Drastic Result.
While piercing the corporate veil is a rare result, the consequences can be a very big deal. In Krausz Puente LLC v. Westall, the owners of a business were personally liable for $4.5 million after the court found that the business owners paid personal expenses out of corporate funds; the corporation was undercapitalized; and financial records and corporate minutes were not properly maintained (even as to the most significant events in the history of the companies). In Stinky Love, Inc. v. Lacy , an entrepreneur was personally liable for $4.3 million where the business owner used the corporation's assets to pay off his personal debts, including credit cards and automobile loans, and money was freely moved between personal bank accounts and those of the corporation.
The danger arises when the business isn't treated as belonging to the corporation rather than to its individual owners. That's why the court will take a look at whether corporate and personal bank accounts were maintained; whether corporate funds were used to pay the shareholder's debts; whether the corporation had its own business address? Were stock certificates prepared and issued? Were shareholders' and directors' meetings held regularly, especially to approve key business decisions? Were minutes of all such meetings properly maintained?
The lesson is clear: the corporation and its individual owners must be treated as separate in order to maintain the protection of the owners' personal assets ordinarily afforded by the incorporation process.
by: Jeffrey Unger
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