Starting a business can be the first step in a thrilling adventure, one that you have perhaps dreamed of for years. But as you start your venture you’re mildly terrified of the outcome. When launching a new business, budding entrepreneurs can hardly slow down long enough to do the bare minimum of forming the proper business entity most appropriate for their new venture and protecting themselves against personal liability if something threatens the new endeavor’s success down the road. As a new entrepreneur, you believe everything will be fine because you’ve got a detailed business plan, some start-up capital, good mentors, and dedicated partners who share a single vision. At least it seems that way when you first start out. While you may have formed a legal business entity, you’re not keen to spend valuable time focusing on paperwork when there’s staff to hire, products to develop, equipment to purchase, and your amazing, innovative idea to bring to the market? That investment in time, however, may save your personal assets from creditors you encounter down the road.
Forming a business entity is only the first act in protecting personal assets from business creditors.
Failing to focus on the less exciting aspects of business ownership can have serious and lasting repercussions on you and your business. No one wants to contemplate the future demise of their dream in its infancy. But taking certain acts to ensure proper company management, even those that seem tedious, will promote the more exciting aspects of your company’s operations and help 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 to protect you.
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 the company follows certain formalities. If the company and its principals fail to do so, a creditor may be able to “pierce the corporate veil” and seek relief beyond the debtor company’s assets.
There is no bright line rule as to whether and when a business’s ownership will survive its creditors’ attempts to pierce the corporation’s veil of limited liability and saddle the individual owners with the corporation’s obligations. A judge or jury will look at a number of interrelated factors, and decide, based on the “totality of the circumstances,” whether the company’s owners have adequately financed and maintained proper corporate formalities to keep the entity from being considered a “façade.”
Among the many factors are:
- Commingling of assets of the company and of its owners.
- Manipulating assets and liabilities to concentrate or hide the assets or transfer the liabilities to avoid creditors.
- Under capitalizing the business entity.
- Failing to maintain accurate corporate records.
- Concealing or misrepresenting the owners of the business entity.
- Failing to maintain arm’s length relationships with related entities.
- Engaging in self-dealing transactions that harm the business entity.
- Failing to observe corporate formalities, document meetings, and transactions.
This is not an exhaustive list, and a judge or jury may consider other factors specific to the particular situation you and your partners find yourselves in.
Fortunately, some rather easy procedures can significantly reduce the likelihood of creditors successfully piercing the business entity’s veil and pursuing the company’s debts from you.
Do not mix business and personal funds.
A company should have and use its own bank accounts. The personal funds of the founders, or other related companies, should not be mixed with your new venture’s funds. Of course, getting a new business off the ground may require one or more infusions of cash by the owners. Those transactions, whether structured as debt or equity, should be okay as long as the infusion of funds is properly documented by your attorney and accounted for by your accountant as a capital contribution or a loan. Your attorney’s documentation, and your accountant’s accounting, if you will, will go a long way toward proving the proper financial independence between the company that received the funds, and the owners or lenders who provided it.
Keep detailed records of the company’s management by both the directors and officers.
Business entities, even those with a single owner or “husband and wife” ownership, should create and maintain a comprehensive corporate book of records, minutes and resolutions. While it may seem unnecessary, even a single-owner entity should have standard governing documents. These can include bylaws, a shareholders’ agreement, or an operating agreement that properly details the company’s management structure, financial management, and proper authorities to act on behalf of the company. Major decisions, such as real property or capital equipment acquisitions, should be memorialized by the adoption of resolutions or written consents approving those actions, even if that requires a somewhat informal meeting over coffee between spouses who are 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 developing products, soliciting customers, and growing the business. But following proper corporate formalities is essential to creating and maintaining the protections against personal liability that business entity formation is meant to provide.