Easy Steps for New Companies to Protect Against Personal Liability
Starting a business can be the first step in a thrilling adventure, one perhaps dreamed of for years and mildly terrifying to begin. Often, entrepreneurs can hardly slow down long enough to do the bare minimum in forming a business entity to protect themselves from personal liability if something threatens the new endeavor’s success down the road. Surely everything will be fine. A legal business entity has been formed. Who wants to spend time focusing on paperwork when there’s inventory and equipment to purchase and an amazing, innovative idea to bring to the market?
Unfortunately, forming a business entity is only the first act in protecting personal assets from business creditors. Failure to focus on the less exciting aspects of business ownership can have serious and lasting repercussions. No one wants to contemplate the future demise of their dream in its infancy. But taking certain actions in company management, even those that seem tedious, can promote the more exciting company operations and ensure personal assets are not at risk if something unfortunate happens. By itself, forming a corporation or limited liability company or partnership is not enough.
New business owners often form a legal entity to prevent liability associated with the business from threatening their personal property and assets. Starting a business from a mere spark of inspiration requires risk -- sometimes significant risk. Even the most intrepid entrepreneur would hesitate if the failure of the business would threaten personal security. Operating a business as a corporation or limited liability company can keep judgments against a company from attaching to the assets of the company’s owners or their other businesses. That is if – IF – the company follows certain formalities. If the company and its principals fail to do this, a creditor may be able to “pierce the corporate veil” and access avenues for relief beyond the debtor company’s assets.
There is no “bright line” rule regarding whether a business can or should survive a veil-piercing effort by a third party. Instead, a judge would look at a number of factors and the “totality of the circumstances” to decide if a company’s operators have adequately maintained the formalities needed to keep the entity from being considered a “façade.” Among the factors are:
- Commingling of assets of the company and of its owners
- Manipulation of assets or liabilities to concentrate or hide the assets or liabilities to avoid creditors
- Undercapitalization of the business entity
- Failure to maintain accurate corporate records
- Concealment or misrepresentation of members
- Failure to maintain arm's length relationships with related entities
- Failure to observe corporate formalities in terms of behavior and documentation
This is not an exhaustive list, and a judge may consider other factors specific to the situation. Fortunately, the following rather easy procedures can significantly reduce the likelihood of a successful veil-piercing argument.
Do not mix business and personal funds.
A company should have and use its own bank accounts. Personal funds (and the funds of other related companies) should not be mixed with business funds. Of course, getting a new business off the ground may require one or more influxes of cash from the owners. That can be okay as long as the cash infusion is properly documented as a capital contribution or a loan. Fortunately, the accounting organization desired and encouraged by an accountant should go a long way toward showing proper financial independence for the company from its principals.
Keep Detailed Records of Company Management
Business entities, even those with a single owner or “husband and wife” ownership, should produce and maintain a comprehensive corporate book of records, minutes and resolutions. While it may seem counterintuitive and unnecessary, even a single-owner entity should have standard governing documents. These can include bylaws, a shareholders’ agreement or an operating agreement that properly detail the company’s management structure and cash flow procedures. Major decisions, such as equipment investments or real property acquisitions, should be memorialized by the adoption of resolutions or written consents approving those actions, even if that requires a very informal meeting over coffee between the husband and wife co-owners of the company. Put simply, there is no penalty from a formality perspective for robust record keeping.
Internal documentation of company decisions may seem like an unnecessarily formal task and an inefficient use of time and money better spent fostering a growing business. But proper formality maintenance is essential to create and keep the protections that business entity formation is meant to provide.
Phelps’ business lawyers offer guidance on “best practices” for new and emerging businesses, including record keeping that facilitates growth without compromising liability protection. Please contact Derek Larsen-Chaney or any other member of Phelps’ Business team if you have questions or need advice and guidance.