How Thick Is Your Corporate Veil?

September 6, 2011

With the nation’s continued hiring freeze and unemployment at a current rate of 9.2% nationally and 6.6% in Minnesota as of July 2011[1], people are hitting dead-ends with their job searches.  As a result, more and more otherwise qualified professionals from all walks of life are turning their professional skills and talents into profitable businesses. While on the surface, this trend appears to be good for the economy and the unemployed, the vast majority of aspiring entrepreneurs rush into business without first establishing the proper business structure to protect themselves from personal liability.

The danger in forming a business entity without the proper legal protection is that it exposes business owners to potential personal liability.  Here is a common misconception. Let’s assume you have been an employee for a printing company for many years but were recently laid off.  You want to form a printing company and are excited to be your own boss and run the company as you have always wanted.  From your years of printing experience, you have learned what it takes to make your business successful.  You are chomping at the bit to start marketing to clients and entering into client and subcontractor agreements, but realize you need to protect yourself personally by incorporating your new business.  Once you set up your entity, you, as the owner, are guaranteed personal protection from your new company’s liabilities and debts, right?

WRONG!

There is a legal concept called “piercing the corporate veil” which allows creditors the ability to move beyond your company’s corporate assets once those assets are exhausted and go after your personal assets.  The Minnesota courts have allowed creditors to pierce the corporate veil when they determine that the corporation is not distinct from the individual and is instead merely an “alter ego” or extension of its owners and is merely being used to advance their private interests rather than a legitimate business purpose.[2]  Thus, the creditors “pierce” or move beyond the “corporate veil” and reach your personal assets to satisfy the unpaid debts or claims.

Minnesota courts have used a two-prong test to determine if creditors are able to pierce the corporate veil and attach debtor’s personal assets.[3]  The first prong of the test, which is the prong focused on in this article, refers to the owner’s relationship to the entity.  Factors which the courts consider for this prong include (1) whether there is insufficient capitalization for purposes of corporate undertaking, (2) a failure to observe corporate formalities, (3) nonpayment of dividends, (4) insolvency of debtor corporation at time of transaction in question, (5) siphoning of funds by a dominant shareholder, (6) nonfunctioning of other officers and directors, (7) absence of corporate records, and (8) existence of the corporation as merely a facade for individual dealings.  The second prong requires the creditor to show that piercing the corporate veil is necessary to avoid injustice or fundamental fairness.

In order to avoid falling into the first prong, there are a number of actions you, as a business owner, can take to minimize the risk of falling into one of the 8 categories mentioned above.  Some of these actions include:

• Make sure your corporate records are complete and up to date;
• Ensure that your operating agreement and member control agreement are drafted for your particular corporate needs;
• Have a business plan prepared and available for review;
• Make sure you have resolutions and meeting minutes evidencing important corporate activity;
• Maintain a separate corporate bank account from your personal account; DO NOT commingle that business account with your personal accounts;
• Make sure payments to members or shareholders are done in compliance with state law and with the member control agreement/bylaws;
• Have a sufficient amount of capital in your business account to cover business transactions and current liabilities;

To conclude, the more effort you put into creating your business entity correctly, the less risk there will be in subjecting you and your personal assets to the debts and liabilities of your business entity.

You may email Ryan D. Kaplan at ryan.kaplan@kaplanlegalservices.com or call him at (763) 463-9360 to schedule a free consultation to discuss options for setting up your business entity and protecting you from liability.  You may also visit his website at www.kaplanlegalservices.com.

Filed under: Entrepreneurship,Legal Protection

Tags: Forming A Business Entity, Limiting Corporate Liability, Piercing The Corporate Veil