One of the primary advantages of incorporating your business, large or small, is to protect your personal assets from business liabilities. When you form a corporation, limited liability company, or similar business entity, a “corporate veil” is created between your personal assets and your business. What most people either don’t know or don’t take seriously, however, is that you must do more than simply form the corporate entity and register it with the state. The entity must be properly managed to avoid the risks of personal loss through a legal doctrine called “piercing the corporate veil.” Simply said, if you don’t want your entity disregarded, don’t disregard it yourself.
Let me tell you about my friend Steve. He’s a great guy, a successful real estate broker and no dummy. During his career he invested wisely in his own real estate portfolio and had significant assets to protect. So, when Steve decided to form his own boutique brokerage, he did the smart thing: he incorporated. He was joined by three real estate agents who were enticed to leave their big-name brokerage because Steve offered them partial ownership in the corporation. They each made a capital contribution to fund the business for a few months until some of their deals closed. In addition to receiving commissions, they split corporate profits at an agreed-upon percentage.
Everything was fine during the real estate market boom. In order to capitalize on the market, they developed the habit of taking almost all the profit out of the business to fund their personal investments. If they ran short, they just pooled the money together to put back into the business to pay the bills. They never found time for meetings or kept corporate records. Then the sudden slowdown came. The market tanked and left the brokerage with a massive debt they couldn’t pay because they weren’t selling property.
Together they agreed to file corporate bankruptcy. Unfortunately, the bankruptcy judge wasn’t buying it. Under the doctrine “piercing the corporate veil”, (in bankruptcy it’s known as “substantive consolidation”) the judge determined that Steve and his friends had so blatantly disregarded the separate corporate entity and used the corporation as a tool for personal business that they were not entitled to protection of their personal assets. Need I go on?
In order to preserve protection against personal liability you must show that you have a real business, not just a sham created to dodge personal liability. While Steve’s brokerage was, in fact, real, the courts won’t uphold protection when the corporate privilege is misused to protect fraud, misrepresentation or promote other injustice. Such misuses include:
- under-capitalization
- a failure to observe entity formalities
- commingling of funds
- insolvency at the time of a transaction
- siphoning of funds by those owning or controlling the entity
- or the absence of corporate records.
