Dear Friends, Colleagues, and Clients,
In this issue of Client Alert, we will examine the concept known as “Piercing the Corporate Veil,” and how this “weapon” is used by skilled plaintiff’s lawyers to reach beyond a corporation to trap assets personally owned by the corporation’s shareholders.
With the advent of the Internet and websites offering low cost incorporation services, many business owners will seek these lower cost alternatives to hiring a business lawyer and can run into trouble. Generally, these online “do-it-yourself” services provide only the most basic incorporation services, often without a lawyer involved, which initially may appear to be saving money for small start-up businesses. However, as the business becomes successful, these business owners fail to “upgrade” to a business lawyer skilled in maintaining their corporations and adopt the necessary corporate governance and procedures to ensure the corporation remains in compliance.
Since the 1800s, the corporation has been used as a means to shield its owners, or shareholders, from personal liability if the corporation loses a suit brought against it and there are insufficient corporate assets to satisfy the judgment. This “veil,” as it is often referred, may only be available if the corporation is (1) properly formed and (2) properly maintained according to the corporate statutory requirements imposed by state law. This issue of Client Alert will explore the “maintained” aspect of the corporate veil.
In all states, a corporation’s officers must adhere to a set of procedures in order for the corporation to be recognized as a bona fide entity. These requirements are not particularly onerous or difficult to meet, but they must be fulfilled every year to prevent running afoul of the law and risk the corporate veil being pierced as a result. Such formalities include, but are not limited to:
- Annual meetings of the board of directors and shareholders;
- Maintenance of a reasonable amount of capital in the business relative to the nature and extent of the company’s business activities;
- Separate company books and records;
- Maintain adequate capitalization in the company;
- Avoid commingling of the personal and company assets;
- Shares of stock should be issued;
- Written shareholder agreement in place before shares are issued;
- Appropriate tax elections are made (S Corp election must be filed within 75 days following the date of incorporation;
- Timely filing of exemption from securities law.
All too often, we find that the business owner fails to properly maintain these aforementioned corporate requirements through neglect, oversight, or naivety. If the corporation is ever sued, the first thing the plaintiff’s lawyer will do is subpoena the corporation’s books and records, looking for any reason to assert that the corporation is not properly maintained. If improper maintenance can be established, the corporate veil may be “pierced,” exposing the shareholders to liability and providing the plaintiff’s lawyer with another party with deep pockets to include in the lawsuit.
In addition to the risk that the corporate veil may be pierced, the failure to follow certain corporate formalities could give rise to the IRS to disregard your form of business entity resulting in unintended income tax consequences for the company and its shareholders. For instance, the IRS requires that a corporation adhere to specific operational formalities in order to be recognized as a corporation for income tax purposes. A business owner’s failure to properly maintain the corporation could result in the IRS disallowing the corporation’s deductions and imputing its earnings and profits to the shareholders, resulting in the under reporting of income. If the deductions are eliminated, the distributions to the shareholders will be subject to double taxation — once at the company level and again at the shareholder level. In short, the consequences of falling short on these corporate requirements can be catastrophic for the shareholders.
Investors – Be Cautious: Many of our readers are investors in private equity and small businesses. More often than not, the investor will have no idea if the corporation is properly maintaining the books and records and complying with other corporate statutory requirements. If a lawsuit arises against the corporation, the passive investor could find himself or herself being named as a defendant in such a lawsuit under the Piercing the Corporate Veil theory of third-party liability.
Stress Test Your Corporation: As we wind down the year, think about stress testing your corporation’s books and records to determine if it will survive an aggressive plaintiff’s lawyer’s attempt to Pierce the Corporate Veil. Add this to your list of New Year’s resolutions and make an appointment to visit your attorney in January after the holidays.
Free Stress Test: If you don’t have a business lawyer to do this for you, my law firm will gladly perform a “stress test” at no charge to ensure your corporation is in satisfactory condition and not vulnerable to the corporate veil being pierced. The old adage, “An ounce of prevention is worth a pound of cure” really applies in this area, as the risk of loss is profound if this aspect of your business is not properly maintained.
Alternatively, if you would rather operate your business with little or no requirement for adherence to these formalities, consider operating as a limited liability company instead of a corporation, as the formalities are not nearly as stringent as that of a corporation.
We hope you find this information to be of value. Please feel free to write or call the law firm if you wish to take advantage of this limited time offer.
Wishing you a safe and joyous holiday season.
Jeffrey M. Verdon, Esq.
Jeffrey M. Verdon Law Group, LLC