Respecting Your Business Entity: How to Minimize the Risk of a Veil Piercing Claim
Perhaps the foremost advantage and justification for the formation of a business entity such as a corporation or limited liability company (“LLC”) is the fact that the personal liability of the entity’s owner(s) is limited to the amount invested in the entity. In other words, a creditor of a corporation or LLC generally cannot reach the personal assets of the entity owner(s) in order to satisfy a claim against the entity.
Too often, however, business owners believe that the simple act of filing articles of incorporation (or, in the case of a LLC, articles of organization) is enough to limit their personal liability for the entity’s business operations. This is simply not the case. There are other steps involved to maximize an owner’s personal liability, especially from creditor claims under a legal theory known as “piercing the corporate veil.”
A veil piercing claim arises when a creditor of an entity can demonstrate that the entity is a sham; i.e., that the entity is not really a separate and distinct “person”, but merely an extension or alter ego of its owner(s) used to advance their private interests or perpetuate a fraud.
Some of the hallmarks of a veil piercing claim include the following:
• Disregard of Corporate Formalities: there is much more to operating an entity than signing and filing formation documents. Written resolutions must evidence the election of directors and officers (or governors and members, in the case of a LLC). In addition, contracts for the business should be signed by an officer or manager on behalf of the entity, instead of by the individual owner(s). Financial records (profit and loss statements, balance sheets, and the like) also need to be maintained for the entity. One example of what not to do is a real estate business where title to the real estate is in the name of the entity’s owners rather than the entity itself.
• Commingling of Assets: once the entity has been formed, a separate bank account must be established and all revenues and expenses must be run through that account. If the owner needs to take funds out of the entity to pay personal expenses, he/she should take such funds out in the form of salary or a distribution; simply writing checks on the entity’s account for personal expenditures is asking for trouble if ever an issue arises with a creditor.
• Use of the Entity for Improper Purposes: in the case of Stone v. Frederick Hobby Associates II, LLC, where a Connecticut court allowed an LLC’s veil to be pierced, one of the key factors in the court’s decision was the following statement made by one of the owners to the plaintiffs: “Go ahead and sue us. There is no money in [the LLC]. Why do you think we set it up as an LLC in the first place?” Suffice it to say, comments such as those are prime fodder for creditors in a veil piercing claim.
With regards to a LLC, while it is true that the LLC itself enjoys greater asset protection as to creditors of its members than a corporation and creditors of its shareholders (namely, that creditors of an LLC owner are limited to a charging order as to monies payable to the owner and cannot exercise the owner’s governance rights), Minnesota’s limited liability company law provides that “the conditions and circumstances under which the corporate veil of a corporation may be pierced under Minnesota law also applies to limited liability companies.”