One of the wisest things new business owners do is form an entity to protect personal assets from liabilities of the business. There are a number of entity forms owners can choose to accomplish this goal. Limited liability companies (“LLCs”) and corporations insulate, to some extent, the personal assets of owners from being attached by business creditors. Personal guaranties can reduce this protection, and no person can limit personal responsibility for his or her own actions. Regardless, use of an entity can significantly reduce the risk that an owner’s personal property will be seized to satisfy business obligations.
This protection, however, can be lost. The concept of “piercing the veil” has existed for centuries. While the concepts were derived using the corporate form, courts can pierce the veil of any entity, including LLCs, if the conditions are right. Judges will often look carefully at entities to determine whether there is any way of attaching the property of the owners. This inquiry essentially comes down to one question: “Are the owners acting as though the entity exists?” If the answer is “no”, then courts will be likely to “pierce the veil” and allow creditors to attach the personal assets of the owners.
The rules surrounding their creation and maintenance of entities are very specific and critically important. Failure to maintain the formalities necessary under the law might allow the court to pierce the veil. For example, entities must have written documentation of certain meetings of the owners and their representatives (the Board of Directors of a corporation, for example). Even if the entity has only one owner who serves as the sole member of the Board, and as the President, and all other officers of the entity, there must be a record of these meetings. It is a simple matter and can be accomplished with one piece of paper, but this formality does not generally occur to the owners of a small business. It is more common than not that there exist no such records, and failure to have these records will make it easier for a court to pierce the veil.
Most importantly, the owners of the business must be extremely careful not to commingle personal assets with business assets. A paper trail must exist to document all transfers between the owners and the entity. For example, if an owner contributes personal assets to the entity, perhaps a desk or a computer, there must be a bill of sale documenting the transfer. This too is a simple matter, but one that is usually ignored by business owners and attorneys alike.
The entity’s bank accounts are strictly off-limits to the owners of the business for personal matters. If an owner needs money to pay a personal obligation, the entity can distribute funds to the owner in the form of a dividend or other legitimate distribution, but the entity’s check must never be written directly to the owner’s creditor. The check must be written to the owner, documented as a distribution by the entity. The owner can then deposit the check in a personal account and use the funds to pay the creditor. Similarly, an owner must never personally pay an obligation of the entity. The owner must write a check to the entity, and the amount must be documented as a contribution to the entity. The entity must then write a check from its own account to pay its creditor. Strict attention to these formalities may add a layer of paperwork and complication to the situation, but it is a very important layer.