Surprise: Forming a Corporation Does Not Protect You From All Personal Liability

Many people believe that forming a corporation (whether S, C or even an LLC) guarantees protection from all types of personal liability. While it is true that, generally, a corporation limits a shareholder’s liability, this is only the case if the corporation is operated properly. Courts have disregarded the corporate entity if the shareholder(s) used the corporation to perpetrate fraud or promote injustice.  The mechanism by which courts do so is called either “piercing the corporate veil” or the Alter Ego Doctrine. Both are essentially the same thing in that the courts pierce through the corporate entity and allow someone to go after a shareholder’s personal assets. In determining whether to pierce the corporate veil and make a shareholder liable a court will look at the following factors (among others):

1) Was the corporation undercapitalized, given the risk inherent in the business?

2) Were corporate assets used for personal reasons?

3) Were corporate assets commingled with personal assets?

4) Were corporate and personal books kept separately?

5) Were corporate actions properly authorized by the board of directors or the shareholders?

To preserve limited liability, minimally, the corporation should:

1) Obtain and record shareholder and board authorization for corporate actions. Conduct an annual shareholders’ meeting, regular board meetings, maintain and accurate minutes as part of the corporate record;

2) Don’t commingle corporate and personal funds, including maintaining complete and proper records for the corporation separate from personal records;

3) Make clear in all contracts with others that they are dealing with the corporation and sign all contracts as such:

[Corporate Name]

By: _______________________________

[Name and Title of Person Signing]

5) Maintain arm’s-length relationship between the corporation and any principal shareholder. Transactions with any of the directors or principal shareholders should be subject to approval by the disinterested members of the board, if any, without the vote of the interested directors, after all the facts material to the transaction are fully disclosed.

6) Start the business with sufficient equity and liability insurance in light of the future capital needs of the business and its inherent risks.

In short, while it may seem cumbersome and time-consuming to maintain all necessary corporate formalities – it is absolutely worth it to maximize the protection of your personal assets.

This post was written by Katia Bloom, Esq.


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