Limiting Exposure to Liability Critical for Small Business Owners

Limiting Exposure to Liability Critical for Small Business Owners

If you’re a business owner, one of the most important legal concepts you need to be familiar with is limited liability. You’re probably somewhat familiar with limited liability if your business is structured as an “LLC” (which stands for Limited Liability Company) or “PLLC” (which stands for Professional Limited Liability Company). Additionally, if you’re a shareholder, you enjoy limited liability for the actions of the corporation. However, courts across the country have recognized certain circumstances where a court can “pierce” the proverbial “corporate veil” and hold shareholders liable for the actions and/or negligence of a company.

The standard used to pierce the corporate veil is murky at best. Many courts utilize different standards. Even courts in the same state apply different tests. Nevertheless, the fundamental idea behind disregarding limited liability is when the shareholder does not treat the corporation as a separate legal person. Courts reason that if you don’t treat the corporation as a separate legal person, then why should a creditor have to? Therefore, when the owner or shareholder of a company fails to treat the company as a separate person, then a court may conclude that creditors do not need to treat the company as a separate from the offending owner.

Here are some common scenarios that expose shareholders to having their limited liability protection stripped away:

1. Neglecting Corporate Formalities

Where partnership law has historically been quite informal (and the liability for owners has been unlimited), the history of corporate law involves significant corporate formalities directors, meetings, quorum requirements, state filings, record dates, fiduciary duties, etc. Even though limited liability companies are not always subject to as many formalities as corporations, they are still quite formal compared to partnerships. This means that if your clients are not having regular board meetings and shareholder meetings in order to properly approve corporate actions, there is a risk that the company is not separate from the owner(s). Many state statutes permit action to be taken by written consent so that a full-blown meeting is not required. One way or another, you need to be sure that your clients are creating a paper trail showing that the company is following the prescribed formalities. Failing to do so invites the accusation that the company and the owner are really just the same person.

2. Improper Accounting and Failing to Keep Track of Monies Paid To, or By, the Owners of the Corporation

There are statutory ways for monies to be paid into or out of the company within which your clients are working. If the company needs funds, they can be raised in a variety of ways. If distributions are to be paid out to the owners, they must be paid in a specified manner. This makes sense if the company is truly a separate person. Unfortunately, in many instances where the company needs money, a shareholder simply deposits money into the corporate account: not as a loan; not to purchase additional shares; but simply because the company needs money. When the shareholder needs money, funds are simply deducted from the corporate account: not following a board meeting approving a dividend; not in accordance with a provision in the company’s operating agreement; but simply because the owner needs money. If the company and the shareholder each have equal access to the other’s bank accounts, then whey aren’t the really one and the same person?

3. Bank Accounts and Financial Relationships of the Owner and the Business are One in the Same

It’s difficult to argue that the company is its own legal person if it does not have its own bank account(s). This is why it is critical, if you’re a business owner, to divest any personal accounts with business accounts. Have a clear delineation for where money goes from business dealings. This will help reduce the risk of being considered a single “person” with your company.

4. Using Corporate Assets for Personal Purposes

This is a common occurrence that exposes you to major liability. Time and again small business owners use their corporate credit cards, accounts, computers and other assets for personal matters. A court could look at this and consider it to be a “comingling of purposes.” This is dangerous territory and encourages creditors to treat the shareholder and the corporation as the same person.

If you’ve committed one of these corporate mistakes, don’t freak out. You can easily correct the issue and reduce your liability exposure. The issue is when the four factors listed above start to add up and occur all at the same time. At that point, the risk of unlimited liability dramatically increases. If you follow the straightforward principle that your business must operate as a separate legal “person” then you are much more likely to enjoy the benefits of limited liability.