In order to avoid day-to-day liability risks when enacting an asset protection plan, a small business owner must pay close attention to recordkeeping and initial capitalization to avoid of the doctrine of "piercing the veil" of limited liability.
A shield, or veil, of limited liability stands between the owner of a limited liability company (LLC) or corporation and the business's creditors. Because of this valuable legal shield created when you formed your business entity, the business's creditors ordinarily can seek payment only out of the business's assets.
When the veil of limited liability is pierced, the business's creditors can reach the owner's personal assets outside of the business. In short, limited liability, perhaps the most important attribute of an LLC or a corporation, is lost.
This is a complete exception to limited liability. Unlike the transaction exceptions in our discussion of limiting liability for contracts and torts, this exception does not apply to a particular business debt. It applies to all of the business's debts, if it applies at all.
Piercing veil arises during litigation
This exception will arise in a lawsuit by a particular creditor of the business, who is seeking in a complaint to impose personal liability on the owner of the business. In other words, the creditor must sue the business owner personally, plead the doctrine of piercing of the veil of limited liability in his complaint, and then prove to the court that the doctrine should be applied to that particular case.
This type of lawsuit is even more likely in a business that has little capital within the business form, where the debt in question is unlikely to be satisfied from the business's assets. In fact, piercing of the veil of limited liability is regarded as one of the most frequently litigated issues involving small businesses.
The courts will apply this doctrine if the creditor can prove either one of two legal theories:
- Undercapitalization. The creditor must prove that the owner intentionally underfunded the entity, when it was formed, to defraud the business's creditors.
- Alter Ego. The creditor must establish that the business owner failed to separate his financial affairs from the entity's financial affairs, and/or observe statutory formalities regarding division of authority within the entity, required meetings, and recordkeeping.
Losing good standing can automatically pierce veil
LLCs and corporations must renew their status annually by filing a report with, and paying a fee to, the state in which they were formed. Failure to file the report and pay the fee will cause the corporation to go into "bad standing" with the state. After a certain amount of time, which varies by state, the state will dissolve the entity.
If this happens and the owner continues to operate the business, the owner is then operating a sole proprietorship if there is one owner, or a general partnership if there are two or more owners. Either way, the owners automatically have unlimited, personal liability for all of the business's debts.
Other events can trigger dissolution of the business and produce a similar result. However, these events can be controlled in an entity's articles of organization and operating agreement, or bylaws.
Don't confuse a failure to renew the entity annually or biannually, which triggers an automatic dissolution, with failure of an LLC or a corporation to register as a foreign entity when it does business in a state other than the state in which it was formed. Here, the failure, in most states, does not trigger dissolution, and the foreign entity's contracts and limited liability remain intact. In some states, however, this failure, too, can cause dissolution.
Balance asset protection to avoid undercapitalization
The undercapitalization theory requires that the creditor prove the business owner intentionally underfunded the entity when it was initially organized to defraud the business's creditors.
You must walk a fine line when using asset protection strategies in your business. From the standpoint of asset protection, you should invest as little vulnerable capital as possible within the business form (as suggested in our discussion of funding the business by using operating and holding companies) because your liability for the business's entity's debts is limited to the investment in the entity. Further, you should have a plan in place to withdraw vulnerable funds as they are generated by the business entity.
These strategies may seem incompatible with the undercapitalization theory. However, with proper planning, you can minimize investment of vulnerable capital within the business form and avoid the application of this theory. Specifically, to avoid the undercapitalization theory, you should avoid doing anything that might result in application of the alter ego theory and focus on the initial capitalization of the operating entities.
Focus on initial capitalization
In an action to pierce the veil, courts examine the capitalization of the business at the time it was formed. Thus, the initial capitalization should be the your focus. Further, because the holding entity will have no direct operating activities, the focus here should be on the entities exposed to liability--namely, the operating entities.
Court decisions establish that if an entity subsequently becomes underfunded because of events unanticipated at the time it was formed, the undercapitalization theory will not apply.
To win using the undercapitalization theory, the creditor must prove fraudulent intent on the part of the owner. This will be lacking when the initial capitalization was reasonable, in relation to the entity's anticipated capital and operating needs.
Adequately financing the entity does not mean the capital contributed has to be vulnerable to the claims of the business's creditors. Adequately financing the entity means supplying the entity with enough capital for its anticipated needs.
Thus, before forming the business or beginning operations, you should prepare a capital budget that projects the business's need for equipment, furniture, supplies and other capital assets. You should prepare a forecast of anticipated operating revenue and operating expenses for the first year, on a quarterly basis. Consideration should be given to financing any anticipated shortfall in this operating budget, along with the capital needs of the business.
Financing the entity adequately does not mean contributing the anticipated capital and operating shortfall in return for an ownership interest in the entity. Court decisions have established that funding the entity with debt (i.e., leases and loans) is a legitimate business practice. In fact, in most cases in which the undercapitalization theory has been invoked, there has been a complete failure to adequately capitalize the entity with equity or debt.
Nevertheless, it would be a mistake to finance the entity entirely with debt. You must take back an ownership interest, In funding the business, you should follow the guidelines outlined in our discussion of using operating and holding companies, where we suggest a mixture of equity and debt financing. The debt component can represent 30 through 70 percent of the capital contributed. A higher debt component may be justifiable, but unnecessary.
Assets contributed for the equity interest can subsequently be encumbered with liens that run to the holding entity or the owner. These liens will adequately protect the asset contributed in return for an ownership interest.
Courts have specifically approved of the use of a holding entity, which owns most of the business's assets, and a separate operating entity, which conducts the business's activities and is funded primarily through leases and loans. Of course, all arrangements between the holding entity and the operating entity, including the establishment of the equity interest in the operating entity, and lease and loans arrangements, should be authorized and in written form.
In one case, a court refused to pierce the veil of an operating corporation under the undercapitalization theory, even though most of the business's assets were owned by a separate holding entity. At stake was liability for a series of promissory notes in default.
The court found that there was a legitimate business purpose behind the arrangement. Because the holding company owned the assets, creditors could rely on the credit of the holding entity through personal guarantees from the holding entity, for example. Thus, it was unnecessary to place ownership of most of the capital within the operating entity. In short, there was nothing fraudulent about the arrangement. Absent any fraud, the undercapitalization theory will not apply.
The focus on the initial capitalization also means that unanticipated capital needs, operating expenses, or losses in revenue should not invoke the undercapitalization theory--even if future capital becomes inadequate, and the owner continues to receive payments for salary, leases and loans made to the entity.
In a case involving a car dealership, the court refused to pierce the veil of a corporation, even though the business's growth meant that the entity became significantly undercapitalized.
The court ruled that the capitalization, at the time the business was formed, was the relevant consideration. The court found that, at the time the business was formed, it was adequately funded. Subsequently, due to significant growth, unanticipated at the time the business was formed, additional capital became necessary. A failure to provide this additional capital was not fraudulent. Thus, the undercapitalization theory was inapplicable.
The court also ruled, consistent with the general rule discussed above, that withdrawals of assets for legitimate business purposes by the owner are not fraudulent, under the undercapitalization theory, even though they leave the business undercapitalized.
In making withdrawals from the business, you must be cognizant of the fraud restrictions imposed by the Uniform Fraudulent Transfers Act (UFTA).
You must also be aware of separate rules in state LLC statutes and state corporation statutes that regulate payments to the owner on account of his ownership interest, such as distributions of earnings, dividends or ownership redemptions.
Do not operate business as alter ego
Under the alter ego theory, the creditor seeking to pierce the veil of limited liability must prove that the owner did not operate his LLC or corporation as if it were a separate legal entity.
It is this "separateness" that forms the basis for limited liability. Ordinarily, the LLC and corporation are recognized as separate legal entities, and each is responsible for its own debts. The owner, as a separate person, has no personal liability for the business entity's debts.
As long as the owner respects this separateness, the business entity will continue to be recognized as a separate entity, and the business entity itself (and not the owner, who is a separate person) will be responsible for the business's debts. The most the owner can lose will be what has been invested into the business entity. In other words, the owner will have limited liability for the business's debts.
However, if this separateness is not apparent in the way the business owner operates the LLC or corporation, there is no basis for limited liability. In short, if the owner acts as if the LLC or corporation is not a separate legal entity, but instead just another side of the owner (i.e., his alter ego), the court may rule that the owner and the entity are one and the same. Thus, the owner will have unlimited, personal liability for all of the business's debts.
In general, to avoid the alter ego theory, you must first form an LLC or statutory close corporation and then you must separate and document ownership of assets. In addition, you must observe the formalities regarding division of authority within the entity, required meetings and recordkeeping must be observed. Finally, you must separate your financial affairs from the entity's financial affairs, as well as separating the financial affairs among all operating entities.
LLCs and statutory close corporations have few rules
Failing to follow mandatory rules imposed on business entities by a state is one of the main reasons courts use in invoking the alter ego theory. The management structure and operating rules for the limited liability company (LLC) and statutory close corporation are extremely flexible. There are only a few rules imposed on these entities by statute. This can be a real advantage in terms of asset protection. This lack of mandatory rules should, to a certain extent, immunize the LLC and statutory close corporation from the application of this theory.
In contrast, a conventional corporation is governed by what are sometimes termed the "corporate formalities."
The management structure and operating rules for a conventional corporation are imposed by statute. These mandatory statutory rules dictate that the corporation be governed by three classes: shareholders, directors and officers. The rules divide authority among these three groups. The rules also require shareholders and directors to hold meetings, at least on an annual basis. The rules define notice and quorum requirements for meetings, and provide strict procedures for waiver of meetings. Adequate records must be kept of all meetings.
It is easy to run astray of these rules. Salary, lease and loan agreements might be authorized by the wrong group, or not authorized at all. Scheduled meetings may not be held or formally waived. These failures are prime ingredients that may allow a creditor to make a claim based on the alter ego theory.
On the other hand, one group can manage the LLC and statutory close corporation: the owners (or a select number of owners.) The management form is selected in the articles of organization (In the case of the statutory close corporation, the necessity of a board of directors would have to be waived in the articles of incorporation.) This eliminates the confusion that can arise when authority is divided among three groups (shareholders, directors and officers), each with its own specific authority.
Further, the LLC is not required, by statute, to hold any meetings. In the statutory close corporation, generally the articles can waive the necessity of a shareholder's meeting.
In each case, the entity is managed by an operating agreement signed by all of the owners. The absence of the division of authority among separate groups, and the absence of mandatory meeting requirements, should make it difficult for a creditor to prove a claim based on the alter ego theory.
Nearly all of the cases in which courts have applied the alter ego theory have involved conventional corporations. Business planners know that this theory will also apply to LLCs, but exactly how it will apply involves some degree of speculation.
The argument advanced above, that the theory is less likely to apply to LLCs and statutory close corporations, because of a lack of statutory formalities, is not yet tested. In short, while this argument is likely to prove out in practice, there is no guarantee that every court will accept this argument.
Separate and document asset ownership
Assets must be associated with a particular entity in order to avoid the alter ego theory. Bank accounts and credit cards should be established in the entity's name. The business entity should hold title to the assets it owns.
Therefore, when assets are transferred to a business entity in exchange for an ownership interest, you must take care to ensure that legal title is effectively transferred. Transfer of real estate and motor vehicles requires that a formal document of title, that takes a certain form, be executed and recorded. In other cases, a written document, that is more flexible in its form, should be used to transfer title.
Frequently, the small business owner will continue to use an existing checking account, stationery or legal forms that were established in the owner's personal name or the old business's name. Doing this can trigger a piercing of the veil of limited liability, because the new business will, in effect, be using assets that it does not own, or have the right to use, under a written agreement.
Close old bank accounts and credit card accounts. Discard unused checks. Open new accounts and credit cards in the new entity's name. Discard old stationery and legal forms. Have stationery and legal forms printed in the new entity's name. The cost of doing this is minimal, especially in comparison to the risk of loss that is eliminated.
Even if you initially separate assets, you can run into trouble if this separateness is not maintained. Be careful to avoid a pattern of co-mingling of assets. If certain assets are mixed-use, you should follow certain guidelines to steer clear of the alter ego theory.
Be careful with mixed-use assets
In some instances, you will personally own mixed-use assets, used for both personal and business purposes. Good examples are your home if you have a home-based business, a computer and an automobile. This can expose you to application of the alter ego theory.
A personal residence should never be transferred to a business entity. Doing so will result in the loss of the homestead exemption.
Further, the small business owner should consider personally owning certain "tools of the trade," including a personal automobile, office equipment and furniture, and then leasing these assets to the business entity. This also ensures that the exemption for this category of assets will continue to be available to the owner.
Of course, such arrangements must be properly authorized by the entity, and in the form of a written agreement between the owner and the entity.
With mixed-use assets that are personally owned, the best approach is as follows:
- You should pay the general expenses associated with the asset from his personal accounts.
- The entity should then, pursuant to a written agreement between you and the entity, reimburse you for the business portion of these expenses.
- Records must be kept of the business usage. For a home, the relative square footage of the business office can be used. For a computer, a log evidencing hours of business usage and personal usage is appropriate. For an automobile, a record of business miles and total mileage driven is required.
- Where a particular expense can be directly attributed in its entirety to the business, this expense should be paid from the business account.
John Smith, sole owner an LLC, uses his personally owned automobile for both personal and business purposes. He records the automobile's mileage at the beginning and end of the year. In one year, he drives 18,000 miles. His log shows he drove 12,000 business miles. This represents two-thirds of the automobile's total usage.
Smith should pay the general operating costs for the vehicle from his personal accounts, because he owns the vehicle personally. He should have a written agreement with the LLC, wherein the LLC reimburses him for two-thirds of all operating expenses associated with the vehicle. This can be done on a weekly, biweekly or monthly basis.
If Smith incurs an expense solely attributable to business usage (e.g., a parking fee or toll on a business trip), this expense should be paid directly from the business's accounts.
The objective here is the separation of the owner's and the entity's financial affairs, to prevent an application of the alter ego theory. However, for tax purposes, a one-owner LLC is a "disregarded entity." Thus, for tax purposes, reimbursement from the entity serves no purpose. For tax purposes, the owner and the entity are one and the same.
Commingling assets can destroy limited liability protection
Co-mingling is a primary basis upon which courts apply the alter ego theory. Co-mingling of assets involves the owner using business resources for personal purposes, or the business using the owner's personal resources for business purposes. When the rules regarding separation and documentation are followed, co-mingling of assets should not occur.
Especially in the case of the small business owner, co-mingling can occur in other instances, because assets and expenses can have mixed (part business, part personal) uses. Adequate documentation of the business purpose of a transaction can ensure that no co-mingling will occur.
In one case, a court refused to pierce the veil of a corporation, even though the owner had used corporate funds to pay what appeared to be his personal expenses, including travel, dry cleaning, telephone, and even housing expenses.
The court found that these expenses could be considered legitimate business expenses. The court based this conclusion on the fact that the owner meticulously maintained separate corporate records and accounts that clearly identified the business purpose of the expenditures. Thus, no co-mingling of business and personal resources occurred, as the expenses paid by the business were business expenses and not personal expenses of the owner.
In contrast, this same court did pierce the veil of a corporation where the corporation paid unauthorized salary advances and unauthorized loan payments on the owner's personal car. Here, the lack of records and authorizations meant that the expenses were not legitimate business expenses, but instead personal expenses of the owner. Thus, co-mingling (paying personal expenses from business resources) occurred.
You should be aware of a fact pattern that afflicts many small business owners: commingling of bank accounts. Many times, there will be insufficient cash available in the business's accounts to pay the business's bills, or in the owner's personal accounts to pay the owner's personal bills. Be aware that this is the situation most likely to result in a co-mingling of resources and this can prove fatal from an asset protection perspective.
Unfortunately, it is also likely that, in this situation, the business will be experiencing financial difficulties. This makes it more likely that the business will undergo scrutiny from creditors who are not being paid. This scrutiny may take the form of a lawsuit, wherein the creditors attempt to prove that the alter ego theory should be applied to the owner and the entity.
A business entity should never directly pay what are clearly personal expenses of the owner.
Michael, a business owner, needs a new roof on his personal residence, which will cost $4,000. However, he does not have sufficient funds in his personal accounts to cover this cost. He does, however, have sufficient funds in his business entity's accounts. This cost cannot be justified as a business expense, at least if the owner conducts his operations outside of the home.
It would be a mistake to have the entity issue a check on the business account payable to the roofing company. This would represent a co-mingling of resources. Instead, the LLC should adopt a written salary agreement and pay Michael a salary. A check from the business account would be issued to the owner, and recorded on the entity's books as salary expense. The owner would deposit the check in his personal account and then write a personal check to the roofer.
However, to avoid a court from "collapsing" the separate transactions into a single transaction and concluding the business paid the owner's personal expenses, it is advisable that the salary does not exactly match the owner's personal expense. It also is advisable to pay salary on a regular basis. Following these two strategies can prevent Note, too, that regular payments from the entity to the owner for leases and loaned assets also accomplish the same goal as a payment of salary.
Similarly, the business owner should never personally pay what are clearly business expenses from his personal accounts.
RGS LLC's telephone bill is due, but the business does not have sufficient funds in its accounts to pay the bill. It would be a mistake for the owner to pay this bill with a personal check or credit card.
Instead, the owner could lend the cash to the entity, under a written loan agreement. It is not necessary that a new loan agreement be executed each time. Instead, an open-end agreement can be used. The entity could use the loaned funds to pay the bill directly from its business checking account.
Observe organizational formalities to avoid alter ego theory
To avoid court application of the alter ego theory, it is important to separate and document ownership of assets. All arrangements between the owner and the entity should be documented. This means that all salary, lease and loan arrangements should be reduced to the form of written agreements between the owner and the entity.
While this may seem to border on the absurd in a one-owner business, establishing such a formal relationship with the entity is significant evidence that the owner is treating the entity as separate from himself. Authorization may require a meeting, or that a waiver form be executed by the business's owners.
Maintain corporate records. You should purchase an LLC or a Corporate Records Kit, which are available at most office supply stores. This kit is a centralized place to keep the entity's articles of organization, operating agreement (or bylaws), resolutions and minutes from meetings, lease and loan agreements, salary arrangements and ownership certificates.
It is important that you use ownership certificates when an equity interest is received in return for a contribution of property to the entity. A kit can be ordered that will contain ownership certificates that are pre-printed with the entity's name. Or a kit can be purchased with blank certificates and then filled in by the owner with the entity's name.
Establish accounting system for entity. It also is essential that the entity have its own accounting system. If this is not done, it will prove impossible to separate the owner's and the entity's financial affairs. Popular accounting software packages, which are generally affordable and useful, include Quickbooks and Peachtree One-Write Plus.
Owners of new businesses will be preoccupied with many issues. With perhaps 60 or 70 hours per week spent on marketing and management issues alone, many small business owners will neglect the business's accounting system.
Ideally, the small business owner should hire a bookkeeper familiar with the software package selected. Admittedly, this may not be realistic in many small businesses, where the budget will not allow this alternative.
In this situation, the small business owner should consider purchasing software and learning how to use it, before starting operations. Many community colleges offer courses or seminars on many popular accounting software packages.
This can also be an opportunity to put your spouse or your older children on your payroll. They can handle the bookkeeping and qualify for important fringe benefits as well.
Hold regularly scheduled meetings. A failure to hold required meetings or execute written waivers has been used to pierce the veil of limited liability in numerous cases through application of the alter ego theory. Both the limited liability company (LLC) and the statutory close corporation can negate the need for meetings.
However, a conventional corporation is required by statute to hold, at a minimum, annual meetings of shareholders and directors. These meetings are governed by statutory rules regarding required notice, quorums, voting, etc. Care must be taken that all of these requirements are followed. The meetings can be waived, if the waiver is in writing and unanimous. Business is then transacted in the written waiver form.
Sometimes the operating agreement for an LLC or a statutory close corporation may require meetings of the management. This may be desirable, for example, in a large, multi-owner organization, to prevent any one individual from carrying out activities without the knowledge and authorization of the other owners.
Where meetings are required by the operating agreement, there may be less of a likelihood that piercing of the veil of limited liability would be applied due to a failure to hold meetings, as the meetings are not mandated by statute. Nevertheless, in this situation, it would be wise to follow the previous advice regarding meetings in the conventional corporation.
In a one-owner entity, or an entity with just a few owners, it may be advisable in the operating agreement to dispense with the need for meetings altogether and instead delegate authority to particular owners to carry out the business's operations. This eliminates a frequent avenue of attack under the alter ego theory.