Protecting The Corporate Veil
Across the United States, it is well recognized that a corporation is an independent entity. As a result, the owners of the company have no personal liability merely by the fact that they own stock in the entity. This rule of law applies even if the corporation has only one owner. This insulation of the personal assets of the owners differentiates corporations from sole proprietorships and partnerships.
In addition to shielding owners from liability for the corporate acts, the use of a corporate form can also provide tax benefits under the right circumstances. Some individuals have become very creative with the use of corporate entities, creating multiple companies under one roof with distinct duties and obligations. For example, a group of individuals could run a business with one entity owning the realty, another running the business, a third providing the labor with a forth providing the equipment.
When properly run, the creation of corporations can make a business more profitable. Unfortunately, in the litigation department we often see the problems that arise when people create these corporate structures but fail to adhere to all of the legal requirements that flow from forming a separate legal entity.
While the law has a strong presumption in favor of preserving the identity of the corporate entity, the courts will “pierce the corporate veil” under certain circumstances. The factors to be considered by the Court in disregarding the corporate form as follows:
Undercapitalization Failure to adhere to corporate formalities Substantial intermingling of corporate and personal affairs and Use of the corporate form to perpetrate a fraud
Lumax Indus. v. Aultman, 543 Pa. 38, 42 (Pa. 1995)
In most cases where the Plaintiff seeks to pierce the corporate veil, one of the initial requests in discovery will be for the production of the corporate minute book. All to often when meeting with a client defending such an action, the discussion over the location of the corporate minute book is met with a blank stare. This then gets followed up with the discovery of the unopened, never used, corporate minute book obtained at the time of the formation of the company. At that moment, the Plaintiff is one step closer to piercing the corporate veil and making the owners personally responsible for the claim.
Small business owners are particularly susceptible to losing the protection of the company as far too often they take money out of the corporation or use corporate funds to pay personal expenses. While the owner is entitled to a salary and a distribution of profits, there remain formalities which must be followed. The noted examples here create not only tax issues but would also cause the corporate veil to be stripped away in a lawsuit.
A more serious problem arises for the individuals who create multiple companies for one business purpose. While there may be some short term gains in terms of reducing insurance premiums and taking advantage of accounting practices to maximize profits, there can be significant long term problems should the entities be involved in litigation.
Our firm was recently involved in a lawsuit with very significant injuries where several of the co-defendants were part of an inter-related group of companies. While the initial strategy behind forming these entities was designed to insulate the companies from liability, in practice it had the exact opposite result. Witnesses were not able to identify the entity that they were actually working for. The same people could not articulate the different functions of each company. The ultimate goal of the attorney representing these parties was to establish that the company that was responsible for the work was also the employer of the Plaintiff. Thus limiting the exposure of the entities to the amount already being paid by their workers compensation carrier. Unfortunately, because the individuals working on a day to day basis did not understand the complex web of companies created by the owners of the company, the company was unable to successfully extricate itself from the case and ended up exposed to a potentially large claim for damages.
The failure to adhere to corporate formalities has also shown to create significant problems when co-owners decide they can no longer work together. When individuals have worked hard on properly creating their business model, an individual leaving should be an orderly process. In the absence of such formalities, though, individuals can get involved in prolonged legal battles over who actually owns the business, what each person’s relative share would be and how the future profits of the business must be divided. In many such cases, the cost of the litigation begins to dwarf the value of the actual business and the end result is that the business everyone worked so hard to develop ceases to exist.
For these reasons, setting up a corporation cannot simply be a one time call to an attorney and the payment of a registration fee to the State. Corporations should periodically review with their attorney their business structure, financial arrangements and operations to ensure that the protections and business model created continue to serve their function. This is a cross discipline approach as there are not only legal questions, but accounting issues and insurance needs which must be periodically reviewed.