by: Arend J. Abel, Attorney

Business owners often form entities such as Corporations, Limited Liability Companies (LLCs) or Limited Liability Partnerships (LLPs). Frequently, such entities are formed at the advice of lawyers, accountants, or other business advisors, to limit the business owner’s liability. But do they?

Business entity formationThe answer, as in so many areas of law and business, is “it depends.”  It depends on both the type of liability and the manner in which the business owner has dealt with corporate matters.

Direct Personal Liability for Negligence or Other Torts

The existence of a corporation or other limited liability entity will not protect an individual who personally engages in wrongful conduct.  So, for example, a small business owner will not escape liability for an auto accident in a company vehicle on company business, if the owner was the driver of the vehicle. Both the company and the driver can be liable, even if the driver is the owner of the company. Similarly, a business owner who personally makes misrepresentations while working can be personally liable for those misrepresentations, although the company will also be liable.

However, if the owner has not personally participated in the wrongful conduct, then the owner will generally not be personally liable, as long as corporate issues and finances have been properly conducted.

Contractual Liabilities

          A business owner is not ordinarily liable for the day to day contractual liabilities of the limited liability entity, such as supplier costs, employee wages and the like. However, to avoid such liability, the business owner must make clear that the owner is signing contracts related to such liabilities in his capacity as an officer or employee of the company. If the owner does not do so, there may be personal liability for the obligations. Significant creditors, such as banks, landlords, and even some suppliers, may require that the owner sign a personal guaranty before they will extend credit. Business owners should carefully review all agreements to make sure that they aren’t agreeing to personally guaranty the company’s debts unless they are absolutely required to do so.

“Piercing the Corporate Veil.”

Even where the business owner would not otherwise have personal liability, there can still be a risk of personal liability if the owner has not acted to maintain a separation between the owner and the business. Under certain circumstances, creditors or other claimants can ask a court to “pierce the corporate veil,” which simply means disregarding the limited liability entity and allowing the claimant to collect directly from the individual owner.

Steps that a business owner should take to avoid personal liability begin at the formation of the entity and continue throughout its life. At the beginning, the owner should provide capital to the business entity, in the form of an equity contribution that is large enough to allow the entity to carry on its business. Frequently business owners form entities and make either a nominal capital contribution or none at all. That is a serious mistake from the standpoint of avoiding personal liability.

During the life of the business, the owner should maintain the separate status of the entity in a variety of ways. The entity should have its own bank accounts and taxpayer or employer identification number. A complete set of books should also be kept for the business entity, recording all of its income, expenses, assets and liabilities, separate from those of the owner or any other business entity that the owner may have.

Equally importantly, money should never be taken directly from the company to pay the owner’s personal expenses or obligations, and the owner should not use assets belonging to the business for personal use. Ideally, if the business is large enough, it can hire the owner as its President or other employee and pay the owner a regular salary as it would any other employee. If the business cannot afford to pay a regular salary, but can only provide returns to the owner on a sporadic basis, then it should provide those funds as distributions of income. In some circumstances, the business can loan money to an owner, but if that is done, the loans should be carefully documented with promissory notes and book entries, and the loans should bear interest at a market rate. Similarly, if the business later needs additional capital and the owner wants to provide that capital by way of a loan, the loan should be documented with a note and book entry and should bear interest.

If the business is a corporation, its board of directors should have at least some members who are independent of the owner and have meaningful decision-making authority. Regardless of the form of the entity, it should hold regular owner/shareholder meetings and regular meetings of its officers, managers, and/or board of directors. Those meetings should be documented in minutes maintained in an official minute book of the entity. Such “meetings” should be held and documented even if there is only one shareholder or owner of the entity.

Finally, the owner and the entity should make sure that third parties clearly understand that they are entering into transactions with the business entity, rather than directly with the owner.

While the steps above do not guarantee that a court will not hold an owner individually liable, they greatly reduce that risk. In addition, they are sound business practices that are routinely followed by larger companies.

A potential business owner can benefit from hiring an attorney prior to the formation of the business. An experienced attorney can consult with the potential business owner to learn how the business will operate and offer recommendations for entity formation that can best protect the individual from personal liabilities in the future. Contact us for a free consultation.

photo credit: Ines Njers via photopin cc