The limited liability associated with Corporations and LLCs is among the best benefits to running a business as an entity rather than on your own behalf as a sole proprietor. But if you are not careful, you can lose that limited liability. (Related Guide: How to Choose a Business Structure)
We’ll explain how that happens in this post and provide tips on how to prevent it.
If you don’t pay your credit card bill or breach a lease with your landlord, you will be personally liable for the damages that result. If a third party gets a judgment against you, they can garnish your wages, place liens on your property, etc.
On the other hand, if a Corporation or LLC fails to pay a debt or breaches a commercial lease, the business will be liable for the damages, but its owners won’t be personally liable just because of their ownership interest. That protection is known as “limited liability.”
Of course, there are exceptions to this general rule.
Courts will not give absolute limited liability to owners of Corporations and LLCs. Rather, in certain scenarios, a court may “pierce the corporate veil” and hold the company’s owners liable for the debts and obligations of the company.
Below are several examples of when your veil might be pierced.
Committing Fraud or Wrongdoing
The biggest reason your veil may be pierced is if you commit fraud or some other wrongdoing to third parties with the expectation that you’ll be protected because you have a Corporation or LLC. Courts won’t allow you to escape personal liability if you are using a Corporation or LLC to commit bad acts.
Another reason you may lose protection is if you commingle your money and your company’s money. This happens a lot in small businesses when owners use their personal checking account for both their personal life and their business life (which is why you should always create a business bank account). And related to this, you should make sure your company has enough funding to operate. If you run a low balance in your company bank account and pay for company expenses from your personal account, you may lose your limited liability.
Failure to Follow Formalities
Your veil might also be pierced if you fail to follow traditional corporate formalities. For example, if you don’t have an operating agreement (for LLCs) or bylaws (for corporations), don’t document company meetings, don’t maintain a minute book, or if you sign contracts on your own behalf rather than on behalf of your company, your veil may be pierced.
(Also note – you will always be liable for your own bad actions. For example, if you are driving somewhere while on the clock and cause an accident, you can’t say “my LLC was driving the car!”)
It’s actually fairly easy to preserve your limited liability.
First and foremost, use a reputable startup or small business lawyer to help you set up your company and give you guidance on following corporate formalities. When you form your company, your lawyer will help you with your operating agreement or bylaws and the creation of a minute book (we always create digital minute books), and will give you advice on opening a bank account, filing taxes, and signing contracts the right way.
(This article is general in nature and is not legal advice.)
Legal knowledge to minimize your risk and maximize your chances of success.
LLCs v. Corporations
Finance & Tax