Structure Your Company to Avoid Personal Liability
Your new business is finally up and running. Although you’ve tried to think through every detail, the one unpleasant issue that no one likes to consider is what happens if your company gets sued?
A sole proprietorship offers no protection against the business owner’s personal liability. Similarly, most partnerships do not offer personal protection for the partners. However, a savvy business owner can protect his or her personal assets from liability by forming a corporation.
The corporate shield, as it is known, will protect the corporation owner’s personal assets from the risk of liability stemming from the activities of the corporation. When business after business seems to be filing for bankruptcy, it makes sense for business owners to protect their assets through incorporation.
Partnerships offer many advantages. They are easy to form, and the profits flow through the partners’ personal tax returns. Prospective employees will be attracted to work for the partnership if they can potentially become a partner.
However, partnerships have disadvantages. For example, the general partners are personally liable for the debts and liabilities of the partnership (and possible for actions of other partners).
Alternatively, business owners can structure the company as a limited liability partnership in which the general partner is financially responsible for all the partnership’s losses. However, the limited partners must be cautious not to engage in the operation of the partnership, or they will lose their limited partner status and open themselves up to possible liability.
Under state law, a corporation is an entity that is separate from its owners. Member assets will not be used to satisfy the debts or liabilities of the corporation. It literally shields the owners’ assets from liability risk. However, the corporate shield is not impenetrable. While it may protect an owner’s assets from liability, it will not shield the owner from liability for personal torts that he or she commits, such as negligence, fraud, and misrepresentations.
In order to fortify the corporate shield, a business owner must treat the corporation– whether it is a corporation, limited liability corporation, or any other variation–as a separate entity. Business owners must keep books and finances separate from their own personal accounts. The more business owner mixes the finances of the company with his own finances, the easier it will be for someone who wants to sue the company to “pierce the corporate veil” and recover against the owner personally.
Business owners should never write checks on the company account to cover personal debts. It is paramount to avoid the appearance that the corporation is a mere sham or an alter ego for its principal(s). If a court examines the relationship between the corporation and its shareholders or principals and finds that their interests are inseparable or indistinguishable, it will hold the directors or officers of a corporation liable and allow aggrieved parties to recover damages against the individuals.
A court also will typically pierce the corporate veil when it determines that the corporation was set up as a sham, merely to protect the assets of the shareholders or owners. For example, an owner could establish a corporation, perpetrate a pyramid scheme through the corporation, and fail to leave assets in the corporation sufficient to compensate the victims. In such a case, a court would set aside the corporation and allow the victims to seek recompense from the owner(s).
An owner can separate himself from the corporation by observing corporate formalities, such as holding annual shareholder meetings, formally appointing or electing directors, holding meetings of the board of directors, filing annual reports with the state, and following the established by-laws of the corporation. An authorized representative of the corporation should record and maintain the minutes of shareholder or board of directors’ meetings.
Company principals must make it clear to clients that it is the company–not the individual–that is entering into a contract. Business cards and company stationary should clarify that the business is operating as a corporation (or other variation). By representing that any business conducted by the corporation is corporate activity and keeping corporate business separate from personal business, an owner can separate personal assets from corporate debt, bankruptcy, and liabilities.
Business owners also can limit liability by securing insurance for wrongful acts committed by the corporation’s officers and directors. For example, A-Side Coverage offers coverage, including costs of defense, to officers and directors for wrongful acts alleged against them in their official capacity. This coverage applies when a company does not indemnify its officers and directors. B-Side Coverage reimburses the corporation for money expended in defending and indemnifying the officers and directors. It does not indemnify the corporation against its own liability. C-Side Coverage covers the corporation for losses it sustains, regardless of losses that the officers and directors suffer.