Does Incorporation Protect My Assets?

The most common reasons a court disregards an entity are undercapitalization, failure to maintain corporate formalities or failure to treat the corporation as separate from the shareholders.

One of the largest motivating factors for business owners to incorporate their business is preventing their personal wealth from being exposed to potential litigation involving the business operations.

Essentially, a corporation is formed to build a legal barrier between the company and the shareholder’s personal wealth, such as their home, vehicles, personal checking and savings accounts, retirement accounts, educational funds and other investments. Because a corporation is a separate legal “being” created under state law, the corporation (and not the shareholders) will bear the risk of a catastrophic event involving the business operations. Thus, incorporation serves to limit a shareholder’s liability to their capital contribution.

Limited liability allows corporate investors to bear more risk. The concept of limited liability for corporate shareholders derives from economic policy and theory: if the potential failure of a business allowed creditors to reach all of a shareholder’s personal assets, a risk-averse investor would be deterred from investing, even if the possibility was small. The concept of limited liability extends beyond the benefit of the shareholders to social policy to encourage investment and stimulate the economy. However, the social policy is not met when applying the concept of a shareholder’s limited liability and would result in inequitable consequences.

The separateness of corporation and shareholder is generally respected if a corporation is sued, and as a result, an unfavorable judgment placed against the corporation. However, a court can disregard the corporate entity and look to the individual shareholder to satisfy a judgment under certain circumstances.

Also known as “piercing the corporate veil,” a court may hold a shareholder personally liable for the corporation’s obligations in order to prevent fraud or injustice. Similarly, in instances in which shareholders operate two companies as if they are actually a single company (with such business practices as unrecorded business transactions between the companies, banking accounts, and other commingled business transactions), courts may find one company is actually the alter-ego of another, and therefore hold that the assets of one may be used to satisfy the obligations of another.

The most common reasons a court disregards an entity are undercapitalization, failure to maintain corporate formalities or failure to treat the corporation as separate from the shareholders.

Undercapitalization
Undercapitalization means the corporation does not have adequate capital requirements. Often this occurs at the corporation’s inception. Simply stated, the court is saying the corporation is merely a paper corporation or the “alter-ego” of the shareholder or of another company.

In Kinney Shoe Corp. v. Polan, 939 F.2d 209 (1991), the United States Court of Appeals, Fourth Circuit addressed the topic of undercapitalization. Appellee Lincoln Polan formed two corporations, Polan Industries, Inc. and Industrial Inc. Appellant Kinney formed a lease with Industrial Inc., which in turn, formed a lease for part of the property with Polan Industries, Inc. Other than the lease, Industrial Inc. owned no assets and had no forms of income. Mr. Polan never put any capital into the company, and as a result, never issued any stock certificates. The first and only rental payment was made out of Mr. Polan’s personal funds. Mr. Kinney filed suit against Industrial Inc. for $166,400 of unpaid rent. Although a judgment was issued, the corporations had filed bankruptcy. Kinney sought to pierce the corporate veil to hold Mr. Polan personally liable.

In holding Mr. Polan personally liable, the Fourth District looked to the totality of the circumstances including the lack of formalities relying on such facts as the lack of corporate officers and use of personal funds for the business expense. The court highlighted the undercapitalization of the corporation stating that Mr. Polan was “obvious” in his attempts to limit his liability and the liability of Polan Industries, Inc. by setting up a “paper curtain constructed of nothing more than Industrial’s certificate of incorporation.”

Failure to maintain corporate formalities
Another way a court can hold a corporation’s shareholders to be personally liable for the corporate obligations is failure to maintain corporate formalities. Corporations are created under state law. However, directors must also follow the laws required by the state of incorporation in order to maintain the corporation’s status.

Each state has its own requirements; some examples include the filing of an annual report with the state and the number of meetings the Board of Directors must convene within a year. If certain formalities are not met, the state may administratively dissolve the corporation, which means the corporation will cease to exist for legal purposes. When this occurs, the owners will be considered to be conducting business in their personal names, as a general partnership if multiple owners or sole proprietorship if a single owner. All liability would become the obligation of the shareholders in a personal capacity, and could be satisfied through their personal wealth.

Separate from its shareholders
Absent administrative dissolution, a court may still disregard the entity and find the individual shareholders personally responsible for the obligations of the corporation. Along with the stipulated legislative requirements set forth by the state of incorporation, common law requirements also must be followed. The spirit of most common law requires the corporation to be kept legally separate from its shareholders. Some factors courts have analyzed include identifying the existence of combined bookkeeping, or commingling between the shareholder and the corporation.

Other examples would include belowinterest loans between the shareholder and the corporation, undocumented monies between shareholder and the corporation, and using corporate assets for personal expenses. Essentially, shareholders treating the business as if it was inseparable from their personal accumulation would motivate a court to do the same. The court is sending this message “because you did not consider this corporation separate from yourself, we do not consider it separate from you.”

Am I at risk?
Will one undocumented payday loan cause a court to pierce the corporate veil and hold a shareholder personally liable for theobligations of the corporation? If I file my annual report late, will the courts pierce the corporate veil? A court will look at the totality of the circumstances surrounding the corporation and its shareholders. It will look at the frequency and the severity of the transactions. How often have the shareholders commingled funds? How poor are the bookkeeping practices? Have the shareholders held the meetings as required by state law?

“The corporation does not have substantial debt”
Many business owners tragically underestimate their own potential exposure as they simply think of such liabilities as the monthly rent, utilities, labor, inventory expense and perhaps incidentals such as an unexpected equipment repair. These uninformed business owners neglect the potential for judgment creditors, or a party to whom a debt is owed after an unfavorable judgment is placed against the company.

For example, a delivery truck of Teleco Inc. driving down the street runs a light and smashes into a minivan, injuring a mother and four children. Aside from injuries, one of the children will require a wheelchair for the remainder of his life.

The court finds Teleco Inc. to be at fault, and awards damages to the mother and four children in excess of Teleco Inc.’s insurance coverage. The balance owed is over $1,000,000. The mother and her children are now judgment creditors. The $1,000,000 owed is now a debt of the company. Although not a systematic debt in Teleco’s ledger, the $1,000,000 debt is now an obligation of the company. (Remember, if they have failed to maintain the formalities of the company, have failed to adequately capitalize the company, the court could disregard Teleco Inc. as a corporate entity and find its shareholders to be personally liable for this obligation).

How can I avoid putting my personal assets at risk?
Minimizing personal asset exposure is best accomplished through a comprehensive asset protection plan to include effective entity structuring. However, entity structuring must not only be properly designed and executed; directors/shareholders must also maintain their entity.

Treat transactions occurring between shareholder and corporation as if occurring between the corporation and an unrelated third party. If multiple corporations exist, separate accountings must also be kept, carefully maintaining these related-party transactions as if they occurred between unrelated third parties. Maintain the corporate formalities set forth in the state in which the corporation conducts business as well as the state of incorporation, such as having annual meetings and filing the annual report with the state. Above all, nothing can replace the invaluable advice of personal and business asset protection planning.