Maximizing the Possibility that Using an Entity For Your Business Will Actually Limit Liability
By: Arend J. Abel, Attorney
Many times, business owners will set up one or more corporations, or other entities such as LLCs, to conduct business. Typically, the entities are created to limit the owner’s liability for the business’s debts, or to protect one business from the liabilities of another business. However, often the owner does not go beyond formation of the entity to take the additional steps needed to maximize the chance that having one or more entities will fulfill those goals. Absent those steps, Courts sometimes disregard the existence of the entities by “piercing the corporate veil” and hold the owners liable for the business’s debts, or hold one entity liable for the debts of another. Here are some steps that can help avoid such a result.
Keep Finances Separate and Document Transfers
The most important step in making sure the entity is recognized as separate from its owner is to keep the owner’s and the entity’s financial affairs strictly separate. Among other things, this requires a good set of books for the entity, and a separate bank account. Multiple entities each should have a separate set of books. Any transfers between owner and entity should be scrupulously documented as loans, capital contributions, distributions, or salary, depending on the nature of the transfer. Transfers between the entities should be avoided, if possible, unless one entity is a subsidiary of another. If one entity is a subsidiary of the other, then transfers from the subsidiary should be documented as distributions or dividends. Transfers from parent to subsidiary should be avoided, but if necessary should be documented as loans or capital contributions. Other inter-entity transfers should ordinarily be documented as loans and, again, should ordinarily be avoided.
Adequately Capitalize the Entity When Formed
One factor Courts look at in deciding whether to pierce the corporate veil is whether the entity was adequately capitalized when formed. Many business owners don’t contribute substantial working capital to an entity at the outset, instead simply moving money in and out of the entity as needed. But the lack of capitalization, and shuffling funds in and out, creates a risk a court will disregard the entity. Given that a business will inevitably have expenses and need working capital, the owner should put in an amount large enough to sustain the business’s expenses for several months, at least. A year’s worth of expenses is even better. The money should be put into the entity when it is formed, in exchange for shares the entity issues to the owner.
Create and Issue Share Certificates
Another step that owners should take is to actually issue share certificates, in exchange for the capital contributions made when the entity is formed. It is surprising how many business owners fail to take this basic step. The absence of share certificates suggests that the owner is doing business in his personal capacity, rather than through the entity. This creates an unnecessary risk of personal liability.
Have Separate Phone Numbers, Addresses and Letterhead
The owner and the business should have separate phone numbers, even if the business number is forwarded to the owner’s line. They should also have separate addresses. If the business is run out of the owner’s home, even a P.O. box as a corporate address helps reinforce the fact that the business is separate from the owner. Multiple entities should also have separate phone numbers and addresses. The entity should have letterhead for correspondence, and if there are multiple entities, each should have its own letterhead.
Use Distinct Names for Multiple Entities
Another factor courts sometimes look at in piercing the veil between multiple entities is whether they share similar names. Avoiding similar names is another way to reinforce corporate separateness between entities.
Have a Management Structure and Regular Meetings
If the entity is a corporation, it should have a Board of Directors. If there is only one shareholder, trusted advisors can act as members. The Board should meet at least once a year. If there are multiple shareholders, they should also meet at least once a year. Even a single shareholder can have a “meeting” at which corporate action is taken. No Board of Directors is required for an LLC, but if there are multiple members, they should have regular meetings. The entity should issue notices before the meetings, and a corporate secretary should document all meetings with minutes. Minutes, notices, and corporate resolutions should be kept in a minute book.
To maximize the chance that entities formed for businesses will effectively shield the owner from personal liability, and will shield the assets of one entity from the debts of another, business owners should consult with an experienced attorney to guide them through the process.