Properly operating liability protection entities to avoid personal liability
Many large companies, small businesses and individual investors alike often utilize simple entity structures to protect their assets from potential future litigation. Such structures are comprised of limited partnerships (LPs), limited liability companies (LLCs), or corporations. Often, the personal liability protection aspects of these structures are touted without regard to how easily such afforded protections can be destroyed and this veil of protection can be pierced.
A cornerstone concept of corporate law is that a corporation (or other limited liability entity) exists in separateness from that of its officers, shareholders, or owners providing for the bifurcation of business assets and liability from those of its individuals. This can only be achieved when this separateness is respected by those same individuals in the operations and finances of the business or entity. When the activities of the shareholders have shown disregard for this distinction and made the entity a mere instrumentality for the transaction of their own affairs, a court may find that separateness entity protections no longer exist, holding an individual liable for the entity's obligations, referred to as “piercing the corporate veil.”
While courts are generally reluctant to pierce the corporate veil, a number of ‘red flag' activities may be present that warrant a closer look for such consideration. While this is not an exhaustive list of factors considered by the court, the following are common occurrences to avoid:
- Disregard for corporate formalities (i.e. meeting minutes, adoption of bylaws or operating agreements, election of officers, annual filings with the Secretary of State, etc.);
- Maintaining separate books and records, distinct for entity/business only accounts;
- Adequately capitalizing the business venture for continued operations; and
- Not titling business assets to the entity's name.
Avoiding a Pierce
- Corporate Formalities. It is vital that an entity not only properly form and document its own existence and operations, but in the case of multiple affiliated entities, documenting the relationships (both organizationally and operationally) between these entities is key. For example, a real estate investor owns a holding company with four subsidiaries: three of which independently own real estate assets and one operates as a leasing and maintenance manager to those properties. Regardless of how simple the operations of the real estate holding entities are, each entity must formally adopt the proper internal governance documents, hold annual meetings, elect officers or managers, and file the appropriate annual paperwork with the Secretary of State. Additionally, each real estate holding entity should have a formal services agreement with the leasing and maintenance entity where it pays ‘arms-length' fees in exchange for such services; all management, administrative, financial, IT and service arrangements must be documented. The absence of such documentation may be enough to destroy any well-planned liability protection structure.
- Separate Bank Accounts. Maintaining separate bank accounts, in addition to separate books and records, is an often overlooked formality. Each entity should be operated and accounted for as if it were its own stand-alone business. The veil can be easily pierced by the comingling of funds. Consider the example above in Section 1., each real estate holding entity, the leasing and maintenance entity, and holding company should maintain separate books and records for all revenues, expenses (including those with related entities), liabilities, ownership, etc. Even though the final profits/losses of all entities are ultimately ending with the same individual investor, all monies should be treated as each entity's until passed through the appropriate channels. Another common pitfall is owners either treating an entity's assets as their personal assets or bypassing entity bank accounts and receiving rent (or other) payments directly to their personal bank account. This is usually clear evidence of an owner's disregard for the separateness of the entities, blurring the lines between what assets are personal and what assets are not.
- Adequate Capitalization. Inadequate capitalization of an entity is not, on its own, enough to justify piercing the corporate veil unless coupled with evidence of intent, at the time of capitalization, to improperly avoid future debts. This is a consideration of the totality of circumstances; in its most simple form, one cannot load an entity with debt obligations in effort to separate such from adequate secured capital in an attempt to remove default and payment risk from one's personal or business assets.
- Title to Assets. Generally, assets should be titled to the entity in which it serves. A clear mismatch of title is another ‘red flag' of comingling and general disregard for entity separateness. In the continued example, the investor would be at risk if the real estate assets were purchased and titled to the investor individually but never properly transferred to the entity receiving rents or claiming ownership.
In summary, the separateness of liability limiting entities is a well-respected concept and the doctrine of piercing the corporate veil is applied when evidence supports that an arrangement is a sham, used to defeat justice, to perpetrate fraud, or evade statutory, contractual or tort responsibility. Regardless, good intent is not a sufficient defense and proper planning with legal and accounting professionals is highly encouraged.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.