When I meet with entrepreneurs who are interested in setting up a new business, I highlight the value of creating a business entity such as a LLC, limited partnership or corporation using a good Lancaster County anecdote – the silo. Instead of having your personal assets and business assets in one silo, creating a new entity allows you to have your personal assets in one silo and your business assets in another. In fact, it would be good if one silo is the traditional gray concrete stave and the other is a low oxygen tower style silo. That way, if something happens in either silo that would create liability, the only assets someone can go after are those in the silo where the problem occurred.
Unfortunately, it takes work and some formalities to maintain your assets in each of these silos. Formation of an entity is not just a box to check which entitles you to unqualified limited liability protection forever: there are important actions that you must take to avoid what is known as “piercing the corporate veil.”
Piercing the corporate veil is a legal concept where a court ignores the limited liability protections of an entity and imposes personal liability on the owners. This concept comes up in litigation where a business cannot afford to pay its debts, either taken on in the course of business by borrowing money, failing to pay creditors, or as a result of a judgment from a lawsuit.
Owners run the risk of personal liability for their business entity’s debts when there is no actual separation between the owners and the business entity. From the outset, the business entity should be sufficiently capitalized. That is, there should be enough cash and assets in the business to actually operate the business. Read more about capitalization in my post on Capital Contributions. In order to establish separation between an owner’s personal assets and the business assets, separate bank accounts should be established for the business. Commingling of assets and making personal purchases out of business accounts makes a strong case for piercing the veil. Further, owners should observe the corporate formalities set forth in the company’s operating agreement, limited partnership agreement or bylaws such as having meetings, voting on major business decisions, and maintaining accurate and current business records for financial and entity transactions. Another factor courts will consider when determining whether to pierce the corporate veil is if there was fraud by the owners in their decisions to incur debts.
In other words, a court may look at your silos and think “wait a minute, these silos look awfully similar. Maybe we should treat them as the same silo since it’s clear that the owner thinks of them that way.”
Thus, when you form your business entity, make sure there are actually two silos and you treat them that way. All owners should read, understand and commit to following the provisions of the operating agreement, limited partnership agreement or bylaws that govern the internal operating procedures of the business. Have the conversation with your attorney about what you should be doing on a regular basis, and make sure you implement systems to accomplish those formalities. Schedule your annual meeting for the same day each year and put it on calendars. Use the annual meeting as an opportunity to review the past year to determine if there’s anything you’ve missed from a documentation standpoint, and take the opportunity to correct it. If your corporate books are out of date or incomplete, review them and take the time to get things back on track now to avoid potential liability issues and avoid disputes among owners about the actual state of the business entity.