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Liability Protection

Once you incorporate you have created a separate and distinct legal entity. You and your new business entity are granted rights by state law and you can enjoy the many benefits of being incorporated. This comes with some administrative formalities in order to make sure your incorporation is going to serve you when you need it the most. Maintaining your business entity is simple, there are a couple critical steps that maintain your corporate veil.

Liability Protection is only as strong as the corporate entity is established and operated properly.

Once you incorporate you have the protection of the “Corporate Veil”. In a legal definition this is a perspective from a liability standpoint that your company is solely liable for its own debts and obligations and its owners are sheltered from them. This comes into play when a creditor challenges your corporation’s separate existence in order to seek satisfaction from the company owners for business obligation. There are several ways that the corporate veil is pierced and we will cover them here so that when you incorporate your business you can maximize its legal protection.

Strengthening The Corporate Veil

We’ll be talking about some examples that can be backed up with case law that clearly show when the corporate veil has protected the owners of a company from business obligations. Simply incorporating isn’t enough, you must operate your business separate from those who own it. This isn’t very difficult and simply following basic guidelines and procedures can make all the difference in the world after you incorporate.

  • Proper Organization: This example is the actual act of incorporating your business. Obviously this should be done properly. When you incorporate your business in your state, simply submitting your articles to the Secretary with state fees isn’t enough. Depending on the form of business you are incorporating, there are some fundamentals that need to be in place. For corporations, issuing stock helps separate the identity of the owners and the business. Keeping records of organizational meetings of the owners and maintaining those on at least an annual basis is a state requirement. If a court sees a defective incorporation, this could expose the owners of the business, however if good faith was shown on many other aspects and only a single point was found to be incorrect, there could be some liability protection. This will depend on other formalities and whether or not those are defective as well. In the case that the business was incorporated and organized properly with an exception of a minor formality, a court could be favorable to allowing separate identities to apply to the case. It is necessary to incorporate your business correctly, organize and operate your company separately through administrative formalities.
  • Signing of Contracts: If you sign a document with only your name, it may not matter that you incorporated. A contract with its terms, signed by its parties as individuals means that the contract is between the individuals. If your business in incorporated and the contract is with the business entity, whoever signs it must place the title and entity name below their signature. For example signing a contract with “John Doe, President – My Own Company, Inc” makes it clear that the contract is agreed to and executed by the president on behalf of the business. If a creditor takes a contract to court with an individual’s name and signature, then that creditor can pursue the signature authority. This is referred to as the corporate instrument. Once you incorporate, always execute agreements, clearly as between the company and the other party.
  • Separate Status: Once you have incorporated, you created a new legal person and only by the actions of the business operators, does this separate status get compromised. A creditor will attempt to show a lack of separate existence and pursue the owners’ personal assets for satisfaction. A court will test the separate existence by reviewing corporate records and seeing if the formalities were abided by as well as reviewing financial records to ensure that there was no co-mingling of funds between the incorporated entity and the owners. Another formality here would be under capitalization, this happens when you incorporate a business with insufficient capital to satisfy business obligations agreed to. If this is the case, the court can find that the instance of the company was created for this purpose and this would appear to be fraud.
  • State Requirements: Every incorporated business needs to follow some formalities. State’s require that an annual report, or statement of information be filed on the anniversary of the incorporation. This is simply a statement of who the officers, directors and sometimes shareholders are and legal business addresses. If this formality is overlooked, your standing with your state of incorporation could be revoked. This is probably the easiest formality and accompanied by a nominal fee.

As you can see the corporate veil and protection offered by incorporating can be compromised in the event that the company was improperly incorporated, misrepresented in an agreement or operated without separation between the business and those who own it. These play a very important role in running your business after you incorporate.

Piercing the Corporate Veil

If the time ever comes where a claim against your incorporated business is greater than the assets of the company, your corporate veil is the only protection you have. This will be initiated by the creditor, who must file suit against the company owners and request that the court impose liability on the owners, personally. In general there are two methods the creditor will use to pierce the corporate veil.

  • Alter Ego Theory: This goes right back to separate existence. After you incorporate, operating your business as a separate entity can void this theory. If you treat your incorporated business as separate and distinct entity from its owners, your creditors will be unable to pursue using this theory. This can be as simple as a shareholder paying a personal bill with a company check. To avoid this, make sure that if you need some extra money, declare it through a shareholder dividend, or distribution. The more detailed your records are, the harder this theory will be to pursue.
  • Undercapitalization: This basically is fraud. If you incorporate a business with insufficient capital in attempt to defraud creditors, then your corporate veil can be pierced. If that was the basis for incorporating your business, then you probably didn’t recognize any of the other formalities either. Most small business owners under estimate the amount of funds necessary when they incorporate their business. Its prudent to have a solid plan to get you up and running.

In summary, and for the sake of this topic, we’ll assume that you plan to incorporate your business properly and are eager to reap the benefits of being an incorporated entity. Simply keeping things separate, documenting important actions and decisions and keeping company funds, company funds, and personal funds, personal funds, you can avoid almost all of the creditor theories on how to pierce the corporate veil. It is difficult for a creditor to do so, however they will know what to look for and where most business owners go wrong. Still courts are very observant on the big picture and if your business is incorporated and operated properly with possibly a minor formality oversight, you may still benefit from limited liability.


Strengthening the Corporate Veil

To incorporate a business means that the business owners are protected by state and federal law that shield your personal assets from business obligations. When you are incorporated, you may have to consider protecting your business from the unforeseen. Here we will discuss different levels of liability protection for incorporated businesses.

Without being incorporated, the business owner is 100% on the hook for business obligations, debts, contractual liability and any events associated with business activity. Once you incorporate, you separate the business from personal affairs and you have a degree of protection. Let’s compare the liability protection between Corporations and LLC’s and identify additional measures of protecting your business.

Protecting yourself from business liability means addressing several fronts, incorporating protects you personally… insurance protects your business

Business Liability Protection: Corporation vs. Limited Liability Company

When it comes down to protecting the business owner’s personal assets from business obligations, the Corporation and LLC offer equal protection through state law. One primary differentiation is that LLC’s lack the long standing history of holding up in court. Corporations have a proven track record of hundreds of years. Any properly organized, operated and maintained incorporated business structure will shield the business owner from obligations related to business activity. It’s important to adhere to mandatory operating formalities and keep formal separation between business and personal affairs. After that, there are additional measures you can take in order to increase the protection offered, after you have incorporated your business.

EXAMPLE:
John owns a flower shop that sells exotic, hard to find and specialty flowers to his community. His business also delivers locally and takes large orders for special events. After a slow year, John had hit his credit limits with his vendors. Bringing in plants and flowers from all over the world, lead to a thousand dollars here and a few thousand dollars there for his floral pipeline. Vehicle payments and store rental lease make up another portion of his business obligations. John was faced with filing Bankruptcy and wound up his business. His total business debt to creditors, vendors and landlord totaled $50,000. Now for the sake of this example, all we will state is that John formally organized his business into an incorporated structure and operated it properly. John’s personal assets, his home, vehicles, bank accounts and any investments cannot be used to satisfy what the business owes. In this case, it wouldn’t matter if John was a standard Corporation, S Corporation or an LLC. The fact that John had the business organized and incorporated is where the liability protection stems from. A Corporation or LLC would not have any more or less protection in this case.

Personal Liability Protection: Corporation vs. Limited Liability Company

Lets take another look at comparing the two entities from a different angle. In this case, we’ll assume that you, the business owner is sued personally. Lets examine the assets that are at risk in a judgement; real property owned, bank accounts, investments, vehicles and corporate stock. Yes, the shares of stock you own in a corporation are assets that can be used to satisfy a judgement. Interest in an LLC, on the other hand, is not considered property that can be awarded in the event of a judgement. Now there is something called a charging order where a court can award a judgement on the profits of an LLC to another party. This is complicated, however possible. This means that the awarded party is entitled to the profits of the LLC, but wait, here’s the catch – the party only receives what is actually distributed. Wait, it gets worse, the awarded party would be held liable to pay taxes on the amount of the profit in the LLC, whether or not any or all of the profit was distributed. Which would make that judgement a liability, rather than an asset. The LLC can provide a higher degree of protection of assets from a personal suit. Corporate stock is considered property, anything the corporation owns is included.

Personal Exposure Exceptions

Even if you incorporate your business and operate according to state and federal formalities, you can still run into a situation where you expose yourself to business obligations. Specifically if you sign a personal guarantee for anything, a loan, line of credit, merchant account, etc. Anytime you enter a binding contract that you guarantee personally, your business structure no longer protects you, personally, in the event the business cannot satisfy the terms of the agreement. Another example is paying taxes, which we should all know. The IRS will pursue the responsible party in the event that taxes are not paid, business or otherwise.

Owner and Manager Agreements

Another critical element that relates to the organization of your business after you incorporate, is well documented agreements and bylaws. This is where you state how the company is managed and allocate powers to managers. For example, an LLC run by two managers may have a clause in the operating agreement that states that no one manager can obligate the business to more than $10,000 without unanimous consent of the managers. If any contract is executed in excess of an amount allowed within internal company documentation, that is an unlawful transaction, where the signature authority of the agreement can be held liable for the obligations and not the business. This can lead to a complex situation, however you can still limit the liability with partner and employee actions through detailed agreements and bylaws.

Another control that can be put into place is how much debt, or compensation for business expenses any individual or held position in the company can incur. If your operating agreement or corporate bylaws dictate how much a company check can be written for with just one signature, you can limit your exposure to poor management decisions. If an owner or manager of a company can only sign a check for an amount less than $10,000 without two signatures, you can further protect the business. These types of activities should all be accounted for in the internal documentation of the business, such as operating agreements and corporate bylaws.

The Unforeseen

So you incorporate, organize properly with great detail to your internal documentation. What happens when disaster strikes? A fire, flood, or criminal act? This is where insurance comes into play. Without it, you make be faced with a loss of inventory that could put a small business under. Perhaps an event that would force a business to keep its doors closed for several months, which could easily close the doors on a small business.

Insurance can be a great tool to help limit liability in other areas. There are tons of them, product liability, theft, fire and flood. Employees and workplaces expose the business to huge liability that should be addressed. Seeking a positive solution to this that works with your needs and amount of liability could mean simply having adequate insurance.