Piercing the Corporate Veil: Don't Mix Business with Pleasure.

The role of good business practices in shielding assets on both sides of the LLC veil.

A client recently asked me what would happen to their valuable business inventory if they get dragged into a lawsuit over, for example, a car accident they or their kids get involved in. Well, if the resulting damages exceed the car and umbrella insurance, some of your assets will likely be up for grabs. But what about business assets? Will they also be on the chopping block?   The answer is: it depends.

In the minds of many, starting a business includes some simple, one-time-formalities: e-file articles of incorporation with the department of state, pay the $125 fee and get an EIN with the IRS to open a bank account. Then, on to the daily chores of growing your business. In reality, however, this is only the tip of the iceberg. In fact, one of the most important aspects of incorporation is not just its creation, but the effective maintenance of a separate and distinct legal entity for the business. Let me explain.

While seemingly a formality, entity separation acts as a powerful shield that protects owners' assets from business liability and vice versa, business' assets from owner's liability. The result is a very powerful tool that stimulates entrepreneurship and risk-taking. In other words, people tend to be more willing to going it alone or set their own shop knowing that their personal assets will be reasonably protected if the venture doesn't go as planned.

For example, injuries sustained by the slip and fall of a customer in the store, or damages from a breach of contract with a supplier should be paid by the business, with business assets. For purposes of this article, I call this "upstream liability." If there isn't enough money to settle the matter, the business can go bankrupt but at least the owners should walk away relatively financially unharmed and ready to move on to their next chapter in life. Conversely, incorporation (especially LLCs) also protects the business against "downstream liability" from the owners, like injuries by family member in a car accident, or unpaid credit cards after a medical emergency. These should be paid by the owner with owner's assets, leaving business inventory, equipment and other valuables untouched.

A corporate veil, however, is not a magic wand that comes with the one-time-formalities I mentioned earlier. When it comes to asset protection, the corporate veil can be as effective as a bullet-proof armor, but also as illusory as a smoke screen. The key is the actual separation of identity between the owner and the business. If the business is merely an alter ego of the owner, the corporate entity is disregarded, or in legal parlance, corporate veil is pierced. It kind of makes sense: we don't want to have people harm or defraud the public while hiding behind what otherwise is a legitimate business legal tool.

No single silver bullet can guarantee asset protection on both sides of the corporate veil. Instead, courts adopt a case-by-case approach by looking at the totality of the circumstances. Generally speaking, the shield works better when owners adhere to good business and governance practices. Let me translate that into some examples:

1. Corporate formalities: not just one-time e-filings, but a well drafted set of corporate documents that include an Operating Agreement; a Buy/Sell Agreement coupled with life insurance, Non-Disclosure and Non-Compete Agreements, Employment Agreements and Manuals, Certificates of Ownership, etc.

2. Governance: acceptable record keeping of minutes and resolutions of periodic meetings where owners discuss business strategy, plans, or important decisions.

3. Accounting: keeping separate books for personal and business finances, and importantly, avoiding intermingling of cash flow: don't use the business credit card for personal spending or vice versa.

4. Insurance: adequate insurance coverage to protect employees, clients, suppliers and others against legal exposure commensurate with the nature of the business.

On aggregate, these and other good business and governance practices signal that the entity is not a shell, conducts legitimate business, and is not the alter ego of its owners. But there is yet another, probably even more compelling reason why owners should care about strengthening the corporate veil: it enhances the value of the business in the eyes of potential investors.

If you run a business and want to learn more about ways to enhance asset protection on both sides of the corporate veil, give us a call at (305) 924-2918 or email us at dcoriat@strategic-a.com for a free consultation.