Observing Corporate Formalities
One of the main reasons we set up an LLC is to create a liability shield between our personal assets and liabilities and our corporate assets and liabilities. But setting up an LLC is not enough. We also have to treat it separately and observe corporate formalities.
Have you heard of “piercing the corporate veil”? All that means is that someone who set up a business entity—like a limited partnership, limited liability company, or company—didn’t follow the rules, so they didn’t get the protections they signed up for.
Imagine someone walks into McDonald’s. They slip and fall on an ice cream cone that had been left on the floor, and they get injured. After all is said and done, they get a judgment for money damages.
That judgment is something they can use to take McDonald’s corporate assets whether McDonald’s wants them to or not. They can garnish bank accounts, foreclose on corporate real estate, and if they wanted, they could even seize the ice cream machine to satisfy their judgment. (In reality, McDonald’s, either directly or through their insurance is going to pay the judgment off first so that never happens.)
It would be absurd to think that the judgment creditor could take that judgment over to Target or Home Depot and use it to start taking their stuff. That’s because McDonald’s is a different entity than Target and Home Depot, and a judgment against one cannot be used collect assets against the other.
The same holds true for the owners of McDonald’s. Whether it’s a franchise owner or shareholder of McDonald’s stock, they are also different than McDonald’s, and the corporation, McDonald’s, Inc., exists to ensure that any judgements against the corporation can’t be satisfied using assets of its owners.
The same holds true for small businesses using an LLC. If your business gets a judgment against it, the judgment creditors cannot take your personal belongings—as long as you’ve been following the rules.
The rules are not complicated, but they’re also not universal. Every state gets to establish its own parameters, so double check what it is in your state (you can Google “Elements of Alter Ego in [state]”).
Generally, though, the courts will take a look at the two parties involved (likely you and your company) and consider the following:
Does one have significant influence and control over the other?
Is there a unity of interest and ownership such that one is inseparable from the other?
Would adhering to the corporate fiction (the separateness of the entity) sanction fraud or promote injustice?
Are funds commingled?
Is one entity undercapitalized?
Is there an unauthorized diversion of funds?
Are the business assets treated as the individual’s?
Is there a failure to observe corporate formalities?
To overgeneralize and make this very simple, “is the individual treating the company as separate?” Is the business bank account only used to pay for business expenses (not personal expenses)? Are all deals between the individual and business treated as an arm’s-length transaction with contracts, invoices, and payments? Are the books kept clean?
Part of the analysis will be a question of whether you’ve observed corporate formalities for your business. Is the business license kept up to date? Do you keep regular corporate minutes?
All of these need to be considered as you run your practice. The last thing you want after a judgment is entered is for courts to consider your business an alter-ego of yours (meaning they’re not separate at all—they’re the same person and therefore they are responsible to pay each other’s debts—no liability protection).