Most small business owners believe running their businesses through a corporation protects them from personal liability. Generally, this is true. However, courts can “pierce the corporate veil,” holding shareholders accountable for the liabilities of a company when it’s found to be the “alter ego” of the shareholders.
“When shareholders use a company as their personal piggy bank, ignore formalities when operating the business and leave no assets in the corporation, courts will not let them be shielded from liability,” says Matthew Montgomery, an attorney at Stradling Yocca Carlson & Rauth.
Smart Business spoke with Montgomery about responsibly maintaining the corporate form.
What protections does incorporating provide?
Corporations provide protection from liability at a level you can’t get as an individual operating as such in the market. It’s a good way of limiting liabilities for shareholders of a company doing legitimate business and following proper procedures.
For example, if a small incorporated business owner has a delivery fleet and a driver has an accident, the company would be liable, and not the owner or shareholder. Also, loans can be taken out through the corporation without the shareholder having personal responsibility for repayment. Further, incorporation shields a shareholder from being held personally responsible for any regulatory or non-criminal violations made by the company.
Are corporate protections limitless?
No. There are rules that guide how a corporation should be run. When they’re not followed, liability for the company’s actions falls back on the shareholder, whether he or she is a startup inventor or running a large corporation with hundreds of subsidiaries. Corporate business formalities need to be followed and a level of capital needs to be maintained to handle liabilities. In instances where the corporation is found to be the ‘alter ego’ of its shareholder, then direct liability can fall on the shareholder.
What happens if someone is using a corporation as his or her alter ego?
Should the company be sued and the shareholder has been incorrectly using the corporate form, even if not explicitly named in the suit, the shareholder will be held personally liable for the damages inflicted.
A company often generates much higher liability than an individual. Without the legal protections of a corporation, facing charges can be catastrophic.
What’s considered an abuse of a company’s corporate status?
Generally, courts look to see if you’re observing corporate formalities, which means they want to see that you’re holding board meetings and important company decisions are being made by a board, so board minutes must be kept.
It’s also common for individuals to loan themselves money from the business or treat it like it’s their own piggy bank. Owners often think they put money into the company and they deserve it back, which is true; but the corporate form has to be respected, so a salary must be approved and paid and loans generated from the company must be proper business loans that bear interest.
How can companies ensure their corporate veil will not be pierced?
Research what your state requires through its department of commerce, such as the necessary officers, records you must have and taxes you must pay. And seek the guidance of limited corporate counsel to ensure you’re following all corporate formalities. This step is often skipped because people think it’s too expensive, but if you have to hire a defense attorney, it’ll cost much more.
Take the time to understand how a corporation protects you. Otherwise, you may unwittingly unravel those protections and become the alter ego of the corporation you’ve created. Dealing with this issue before it becomes a problem will save you countless dollars and a lot of headaches.