Business Legal Liability – How to Prevent Piercing the Corporate Veil

A corporation is a separate legal entity recognized by the national and state governments, and the Internal Revenue Service. In a properly run corporation, the shareholders, officers and directors (the company principles) are distinct and separate from the corporate entity, whether a “C,” “S,” or LLC. This provides a “corporate veil” that protects the principles from liability during a lawsuit against the corporation.

As a matter of course plaintiffs in a suit against the corporation also name the principles as defendants whenever possible. This allows the plaintiff to try and include the assets of these individuals in the settlement of the case. Thus the plaintiff will attempt to pierce the corporate veil to make sure there are enough assets to satisfy any judgments from the suit. Yet one of the reasons for forming a corporate entity (C, S or LLC) is to avoid this condition or liability to the principles.

If the principles of the company formally treat the corporation as a separate legal entity, the court will uphold the status of the corporate veil and limit the suit to the corporation, and not include the principles in any judgment. Federal or State Securities Exchange Commission (SEC) investigations typically follow the same approach. The determining factor is how well the principles maintained the separate entity status. If the various corporate formalities are not consistently followed then these are grounds for piercing the veil and holding the principles personally liable.

The smaller the company the more difficult it is to take the time to observe the following formalities, but it only takes one law suit, or the threat of one, to see the value. This can be especially hard if the entrepreneur has been operating as a small business or solo operator for some time, and has not developed the more formal, larger company practices. Once these processes get set in place they will become habits and are easier to maintain. As the company grows many of these best practices actually get easier to implement as the appropriate systems get put in place.

Annual Filings:

Maintain any annual corporate filings of the annual report and fees as required by your state.

Corporate Bylaws

The Corporation must adopt a set of bylaws, or operating agreement for an LLC, which provide a written statement of how the internal affairs of the corporation will be handled. Included in the bylaws are the set time and place of regular shareholder meetings and meetings of the board of directors. For an LLC, which can have a Board of Advisors, this can also be stipulated even though the Advisors do not have the same legal status as “C” corporation Directors. The more a LLC operates like a “C” corporation, the stronger the veil.

Corporate Minute Book

This book contains a written record of actions by the shareholders and directors and is the record that the Bylaws/Operating Agreement was followed. At a minimum, it must include annual minutes reflecting the election of directors by the shareholders. Any significant corporate activities, including corporate business plans, major contracts, borrowings, purchases, and the payment of compensation to officers, should be reflected in the minutes of the meetings.

Board of Director Meetings

Annual board meetings do not provide much oversight. For start-up companies it is highly recommended that monthly BOD meetings be used to manage per the business plan and approve major decisions which are then recorded in the Corporate Minute Book (File or Log). LLCs can do the same with the Board of Advisors or an Operating Committee.

Stock Ledger Book

The corporation must maintain an accurate and current stock ledger book (or membership units for a LLC). This book shows who has been issued stock/unit certificates, the number of shares/units issued, and the value received by the corporation for the issuance of its stock/units.

Conducting Business in Corporate Name

When doing business with third parties, the officers and directors must make it clear that they are acting on behalf of the corporation and not in their individual capacity. Correspondence should be sent out under the proper corporate letterhead or stationary, and contracts should be entered into only with the proper corporation as a signatory. That is the signature block should indicate both the principle’s formal title and the company name.

Bank Accounts

Avoid any appearance of co-mingling of funds. Corporate bank accounts and accounting records must be separate and distinct from the individual. A corporate bank account cannot be treated as if it was the account of an individual officer or director (as often happens with solo or small business owners). Corporate income and assets must be separately accounted for on the company books. One of the biggest mistakes made is to move money and property back and forth between themselves and their corporation without properly accounting for such movement in the corporate records/accounting system. This is a fatal mistake, and the corporate entity will be disregarded by the court.

CFO Check Signing

This is a hard one for many small business owners transitioning to a larger business structure. The Founder/CEO should no longer sign any checks, instead have the CFO or another officer plan ahead and sign all checks and use a system like QuickBooks to print the checks. A two-man rule for signing checks is valuable, but most banks will not enforce this rule so your CFO must be charged with this responsibility. This should also be at least a quarterly audit item.

Payroll Processing

Until you can afford your own payroll department, for any payroll checks use a payroll processor to issue the checks and calculate the appropriate withholding deductions and maintain the appropriate escrow accounts.

Corporate Credit Card

Get a business credit card, and/or debit card, to keep track of all non-check payments. Have your accountant/CFO reconcile them monthly.

Expense Reports

Use an expense report system for all payments to individuals other than compensation. This provides a written documentation for any audits. Be especially careful of all travel and business meeting expenses.

The formal procedures to maintain the corporate veil can be cumbersome to small companies, but are worth their weight in gold should there be any kind of law suit against the corporation or an SEC investigation against the principles. In any lawsuit the plaintiffs will typically name the company principles, and try to pierce the corporate veil to assess the liability directly to the officers and directors. Consistent use of formal procedures can provide the needed protection.

Disclaimer: This is not legal advice. Seek competent legal counsel for both general corporate and SEC related issues, which are far more extensive than these best practices.