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How Much Does Incorporation Protect You?
Many builders incorporate, in part, because of the limited liability a corporation affords, and because of its tax attributes. However, incorporating your business is no guaranty of avoiding personal liability.
In certain situations a court will disregard the corporate entity and hold the individuals personally liable for corporate acts. This is referred to as “piercing the corporate veil.”
Read on to learn about the many situations that can cost a builder the protection of limited liability provided by a corporation.
I pop an imaginary water balloon at periodic meetings with clients who own close corporations. Those in attendance almost always get the point ― if a court pierces the corporate veil, there is going to be a mess.
The Focus Is Shifting From Public to Private Companies
This year, the focus of businesspeople and their attorneys is certain to shift from public companies and the Sarbanes-Oxley Act to private companies, as courts continue to hold individual shareholders responsible for corporate acts. While courts generally support the corporate/limited liability company form, judges will be increasingly vigilant at piercing the corporate veil when the formalities are ignored or when there are supportable allegations of fraud.
To avoid problems, I tell my clients to issue stock, elect directors and maintain corporate records, and to do all of this annually. I tell them to keep separate funds and to deal with related entities at arms' length. I also tell them that sharing office space, addresses and telephone numbers is also a big no-no, unless treated with proper formalities.
Despite how easy maintaining a separate identity can be, private corporate executives continue to disregard the guidelines. I think the key is strong business counseling and industry awareness.
Business Practices That Should Give You Reason to Worry
Private business owners maintain the advantage because judges are reluctant to penetrate the holy shroud that surrounds business entities. That said, in a 2004 decision that set the stage for more focus on the issue this year, a federal judge in the Southern District of New York, in JSC Foreign Economic Ass'n Technostroyexport v. Int'l Development and Trade Services Inc., reiterated that if some or all of the following factors exist, shareholders had better start worrying:
- The absence of corporate formalities, i.e., the issuance of stock, election of directors, maintenance of corporate records, etc.
- Inadequate capitalization
- Funds that are used for personal, rather than corporate, purposes
- An overlap in ownership, officers, directors and personnel
- Common office space, address and telephone numbers of corporate entities
- A lack of business discretion displayed by the allegedly dominated corporation
- Non-arms' length dealings between the related corporations
- The payment or guarantee of debts of the dominated corporation by other corporations in the group
- The use of the property of the corporation in question by other corporations as if it were their own
If one or two of the above issues creep up, there may not be a cause for concern, but if more than that pops up, clients need to take steps to rectify things. If there is a practice of sloppy bookkeeping or mixing things up between entities or with their personal finances, lawyers should bring a filled water balloon to their next client meeting.
How difficult is it to have separate bank accounts, minute books, records and addresses? Frankly, if it is too difficult for clients, lawyers should consider advising them to consolidate their businesses, because they will eventually be skewered.
Interestingly, while a limited liability company (LLC) is often viewed as a hybrid between a corporation and a partnership, many of the same rules governing corporate veils that apply to corporations apply to LLCs.
Unlike C-corporation shareholders, LLC members can report expenses and income on their personal tax return for pass-through taxation purposes. They can also deduct health and life insurance benefits.
But, like a corporation, an LLC has documentary formalities, e.g., operating agreements and articles of organization, that must be executed. The veil that exists in corporations and the rules for piercing that veil would seem to be the same for LLCs and, probably, limited partnerships, but in each case all of the rules have to be followed.
Perceptions Count, So Use Common Sense
While private companies remain outside the purview of the Securities and Exchange Commission and free from most federal corporate governance restrictions, their executives need to engage in serious and honest operations with all formalities observed.
If the law is too confusing, I tell people to use basic common sense because perceptions count — sometimes as much as substance. If that doesn't work for you in 2005, I have some extra water balloons.
R. Randy Lee, Esq. is chairman of The Building Industry Association of New York City, Inc. and a member of the Executive Committee of NAHB and the chair of its legal and litigation programs. He is also the managing partner of Lee & Amtzis, LLP, a New York law firm representing builders, developers and lenders in NYC.
For more information, e-mail Lee.
Excerpted from The National Law Journal Volume 27; Issue 36, May 16, 2005.
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