Many companies choose to do business through a corporation or other limited liability entity (like an LLC). The reason is because a corporation is its own separate “person,” so shareholders or members are not liable for the company’s obligations or debts. This is true whether the corporation has a single shareholder or hundreds of shareholders. However, to take advantage of this benefit, the corporation’s affairs must actually be kept “separate” from the personal affairs of its shareholders.
For individuals who are running a business through a corporation or LLC with one or a few shareholders/members, it takes extra care to keep business matters separate. Failure to do so may leave shareholders vulnerable to being sued personally for the liabilities of the corporation. This is referred to as “piercing the corporate veil” and allows someone having a judgment against the corporation to go after its shareholders’ personal funds and assets to satisfy the judgment.
To illustrate how this works, let’s use an example:
X runs a restaurant owned and operated by Restaurant Corp., of which X is the sole shareholder. Vendor, who sells fresh produce to the restaurant, claims that it is owed money on certain invoices that were issued to Restaurant Corp. Vendor sues X and Restaurant Corp. Ordinarily, X is not personally liable for the invoices. However, if X did not maintain sufficient separation in its operation of Restaurant Corp., the “veil” of limited liability can be broken, allowing Vendor to go after X, and X’s personal funds and assets, to satisfy any judgment Vendor obtains from the lawsuit.
The following do’s and don’ts comprise the threshold best practices to avoid personal liability:
- Establish the governing document for the entity. For a corporation, this is the Bylaws; for an LLC, it’s the operating agreement. These documents provide a set of rules that govern how the entity is managed, how decisions are made, and what formalities must be complied with before certain types of decisions can be made.
- For corporations: have the required shareholder/director meetings. Bylaws (and sometimes operating agreements) require formal votes by members/shareholders to make certain decisions, such as purchasing a new asset or taking on debt. This is a formality that many closely-held corporations don’t follow because it can be inconvenient and seem unnecessary. However, you can tailor bylaws to allow physical meetings to be avoided if all shareholders/directors consent to the action being voted on. This usually entails a written resolution signed by the shareholders. For LLCs, this is less of an issue because operating agreements may be tailored to limit the requirement of meetings or votes to specific significant actions or events (like significant asset sales or buyouts). When in-person meetings are held, it is important to prepare and maintain written “minutes” which summarize what was discussed at the meeting, what votes were held and the results of the votes.
- Have employment agreements in writing. When the same individual is both a shareholder and an officer who earns a salary for running the day-to-day operations of the business, a written employment agreement between the individual and the corporation can help establish the necessary separation. In an LLC, this may also be covered in the operating agreement.
- Maintain good records. Documentation should be maintained of all resolutions, agreements, stock ledger (if a corporation), payroll and other expenses, and tax returns.
- Do not carry out business transactions in your personal name. For example, if you make a purchase order or sign an agreement to buy something for the business, don’t buy/sign as yourself. It is the entity who is the buyer and you (as officer or employee) act on behalf of the entity. If the vendor mistakenly names you, and not the entity, on an invoice, ask them to send you a corrected invoice issued to the entity.
- Do not commingle corporate and personal funds. You should maintain a separate bank account for corporate revenues and expenses. In addition, do not use corporate funds for personal matters (personal loans, personal expenses, advances for personal reasons unrelated to services provided to the corporation).
Unfortunately, individual shareholders are sometimes improperly sued for corporate debts and obligations because the plaintiff believes the corporation does not have enough assets on its own to pay the debt. This is especially true if the corporation is defunct or close to it. Suing shareholders individually is also sometimes improperly used as a tactic to try to force a quick settlement. In these situations, the best defense is usually that the corporation/LLC and its shareholders/members have consistently adhered to the applicable formalities of the entity, outlined in the “do’s and don’ts” above.
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This post does not constitute legal advice or establish an attorney-client relationship.