For those who operate or plan to organize a small business as a corporate entity or limited liability company (LLC), the goal is to shield oneself and other stakeholders from personal liability for debts of the business. Many clients ask: “How do I know that I am actually protected?” The truth is, under certain circumstances you are not, as liability protection is not absolute. This article explains common breakdowns in liability protection and discusses measures that owners of limited liability entities should take to minimize potential exposure.
Limited Liability (the General Rule)
As a rule, corporations and LLCs are entities separate and distinct from their shareholders and members, respectively. A resulting advantage is that such owners generally are not liable for the debts of the entity. In certain situations, however, the legal distinction between entity and owner may be stripped away, leaving business owners personally exposed to company liabilities. This is commonly known as “piercing the corporate veil.” Courts are reluctant to pierce the veil because the paramount purpose of limited liability entities is to personally shield owners, but courts will readily do so to prevent fraud or injustice.
When Will Courts Pierce the Veil?
Piercing most often occurs where the business entity is the owner’s “alter ego,” meaning it is a façade or mere instrumentality used to perpetrate fraud or elude creditors. In applying the “alter ego” theory, courts focus on the reality of how the business was operated and the individual owner’s role in such operation. Typically, the owner operates the business for his or her own individual dealings, using the entity as a mere shell. Such lack of regard for entity separateness and formalities can lead to trouble.
It should be noted that, while Minnesota and Wisconsin courts use slightly different tests for piercing the corporate veil, they are based on the same general principles. In Victoria Elevator Co. v. Meriden Grain Co., the Minnesota Supreme Court set forth the following factors for determining whether an entity has been operated as an “alter ego”:
- Insufficient capitalization for purposes of corporate undertaking;
- Failure to observe corporate formalities;
- Nonpayment of dividends;
- Insolvency of debtor corporation at time of transaction in question;
- Siphoning of funds by dominant shareholder;
- Nonfunctioning of other officers and directors;
- Absence of corporate records; and
- Existence of corporation as merely a façade for individual dealings.
Some number of the above factors, but not all, must be present for a court to find that an entity has been operated as an “alter ego.” Additionally, the court must find that piercing the veil is necessary to avoid injustice or fundamental unfairness to the creditor. In other words, a creditor cannot be unfairly ripped off while the business owner hides behind a liability shield that he or she does not deserve based on the way the business has been operated.
Common Dangerous Situations
1. Insufficient Capitalization and Insolvency
Perhaps the main reason why a creditor would seek to pierce a company’s veil is when the company has insufficient assets to satisfy a creditor’s claim. This is not to say that every company with a cash flow problem is at risk. In fact, there is no bright line rule for determining whether a company is undercapitalized. Rather, it depends on the specific facts of each case.
Where a company has insufficient capitalization from the outset of its formation, it suggests that the company was designed as a sham all along. To illustrate, it would be unwise to form an LLC for the purpose of facilitating large real estate transaction but only contribute a small amount in start-up capital (e.g., a few hundred to a few thousand dollars). If a law suit arises, a court will take into account such small capital contributions when deciding whether to attach personal liability, especially where not doing so would be unfair to the creditor.
With regard to insolvency, there is no rule that businesses must always have full coffers to preserve limited liability. However, a company should not enter into a transaction if it is aware of potential insolvency. For example, a taxi company should not undertake a fleet expansion when it’s struggling to meet its current obligations on the cars it owns. Ultimately, businesses must be adequately capitalized for the purposes of their particular operations. Companies with low liability risk and low capital needs may be just fine with marginal capitalization, whereas companies on the other end of the spectrum require more.
2. Failing to Follow Organizational Formalities
Corporations and LLCs each require different organizational formalities. These range from holding annual meetings, to keeping accurate and detailed minutes on the company books, to maintaining necessary officer positions, and so on. Piercing the veil aims to remedy situations where owners ignore organizational formalities because such ignorance renders the formalities meaningless and indicates a lack of regard for the separateness of the entity. If an owner does not treat the entity as distinct from himself, then a creditor should not be forced to either.
3. Siphoning or Comingling Funds
Particularly in smaller, solely-owned or family-run businesses, owners may find it enticing to buy the kid’s birthday presents or pay the dog’s vet bill out of the company account. Hey, the money would be going toward the owner’s salary anyway, right? Bad idea. Again, this exemplifies lack of separation between entity and owner. Thus, it gives a court less reason to insulate the owner from the entity’s debts and more reason to pierce the veil.
Measures to Protect Yourself
To help avoid personal exposure for the debts of a corporation or LLC, owners should: (1) play it safe with initial capitalization and maintain solvency for the particular operations of the business; (2) strictly follow all formalities required of entity; and (3) keep personal finances separate from business finances. While these are not the only measures to take, they are prominent considerations. Ultimately, a court’s decision to pierce the veil is subjective, and there are no hard and fast rules for holding an owner personally liable.
In closing, if you are the owner of a limited liability entity, you should think of your business as an automobile. There are certain steps you must take to get it started, to keep it running smoothly, and to ensure its working parts remain in compliance with the law. The difference is that an automobile comes with an owner’s manual to ensure each of these things. A corporation or LLC does not. Seeking advice from a knowledgeable attorney can ensure that you are properly maintaining your business, which will reduce the risk of losing the very protection you expect from your corporation or LLC.
*** DISCLAIMER: This article should not be deemed legal advice. You should always consult with an attorney about your specific circumstances and legal rights and obligations. ***
Paul Loraas is a shareholder with Fryberger, Buchanan, Smith & Frederick, P.A., in Duluth, MN. He has been practicing corporate law in Minnesota and Wisconsin since 1995. This article was co-authored with Aaron Kolquist, a recent J.D. and M.B.A. graduate from the University of North Dakota.