It is very important to understand the process for creating and maintaining a corporate veil to protect everyone involved.
How To Maintain Your LLC’s Corporate Veil
LLCs offer a way for business owners to protect against personal liability, among other things. However, forming an LLC (How Do I get an LLC?) for personal liability protection is just the beginning and not the end. Here is what smart business owners should do for maintaining limited liability protection a.k.a. the corporate veil.
Corporate Veil
Business entities such as corporations or LLCs exist, among other things, to protect the owners from business debts. The corporate veil is the term generally used to describe this protection.
If you think that forming an LLC alone is enough to protect you from business debts, you need to learn a lot more. If the LLC has a debt that isn’t paid, there is always the possibility of creditors suing the business owners. They assert that business owners are personally liable for the debts in the name of the business. The commonly used term for this phenomenon is piercing the corporate veil. Creditors might succeed in piercing the corporate veil in particular situations such as:
- Undercapitalized company
- Failure of business owners to maintain a separate identity from their business affairs
- Fraudulent or wrongful actions by the company
Maintaining Corporate Veil
Business owners need to be smart about maintaining the corporate veil. Here is a list of basic guidelines that every business owner should follow:
1. Adequate Funding
The business needs to be sufficiently capitalized. It should be able to take care of its liabilities otherwise creditors will assert that business owners did not maintain proper independence or separation from the business. This is why business owners should always fund their LLC sufficiently, especially at the start, to dispute any such potential assertion.
Every business struggles at the beginning as money is always tight. However, business owners need to provide enough capital to reasonably cover all the initial setup costs as well as liabilities. The funds should be enough to ensure timely payments to creditors and to cover potential liabilities to third parties. It is possible to reduce the risk of successful corporate veil piercing by maintaining the solvency of the company, especially when starting. Solvency simply means that the company has more assets than liabilities.
2. Keep Things Separate
A business entity should operate as a separate entity. It should maintain a separate bank account and credit card and keep its business transactions separate from business owners. Company money should only be used for business purposes. If owners want to use company money, it should be documented as a draw or a loan. If a business needs money and owners provide the funds, it should be documented as a capital contribution. Proper documentation should be created at that time to record the contribution.
Here are the steps to follow for establishing a separation between business and personal finances:
Get a business credit card and a business bank account to be used solely for business purposes. It will ensure that business transactions are kept separate from the personal transactions of the business owners.
Every business expense should be documented in the book of accounts. Several accounting solutions are available. One popular cloud-based accounting solution is Xero which can help with bookkeeping.
If a business needs funds and owners want to contribute those funds, it should be properly documented in the form of a written agreement between the LLC and the owners. A promissory note could be used for this purpose. There should also be a supporting resolution where the transaction is authorized by the LLC.
3. Using the Correct Sign
All the business dealings related to the company business should be carried out in its name. The company should be named party in all contracts. The individual signing the contract should clarify that they are signing on behalf of the company. For instance, they should sign as Anna Smith, Authorized Member of XYZ LLC, for and on behalf of XYZ LLC. This sign clarifies everything as it mentions the name of the signer, their title as well as the name of the company on whose behalf they are signing the contract.
Maintaining this separation is important. When you sign on behalf of the company, it shows that you, as an individual, are separate from the company. If you sign a contract only under your name, there is no way to prove that you have signed it on behalf of the company. It could always be argued that you have signed it in an individual capacity making you liable. Maintaining this separation shows that you can never be held individually responsible for company liabilities.
4. Maintain Necessary Documentation
If the operating agreement of the LLC requires documentation of all the meetings of the company, appropriate records should be maintained. Minutes of the meetings should also be documented. All the company decisions should be reflected in resolutions that are signed by its members. A common term used for these tasks is Corporate Formalities. Formalities might not seem an important enough term as it implies that these tasks are just for formalities and are not a necessity. However, these tasks are extremely important when it comes to establishing and maintaining the corporate veil.
It is important to maintain this documentation. As an individual, you are not required to document all the decisions you make as you are personally responsible for your actions and you always remember why you took certain decisions. An LLC is a separate entity in itself which means it is completely different from you. As an entity, it does not remember any decisions that have been made on its behalf and the reasoning for those decisions. This is why it is important to document everything. Maintaining a paper trail will go a long way in maintaining the corporate veil. It demonstrates that the company’s affairs are being treated separately as an entity.
5. LLC Maintenance
Depending on the state where you have incorporated your LLC, you might be required to file an annual report. Some states automatically dissolve an LLC in case an annual report isn’t filed. If the state dissolves your LLC, you won’t have any limited liability protection as an owner of the business.
Corporate Veil Has Its Limits
Corporate veil isn’t an all-powerful concept. It has certain limits. Even when everything is going perfect such as a perfect separation between the identity of the company and the owners, the corporate veil might be pierced making the owners liable to creditors for debts of the company. Here are the situations where it might happen:
1. Personal Guarantee
When creditors lend money to an LLC, the owners are generally asked to give a personal guarantee for business obligations. For instance, a personal guarantee is needed when signing a business loan agreement or a commercial lease agreement. A personal guarantee is nothing but a voluntary agreement to waive away the protections offered by the corporate veil. A personal guarantee is personal which means you are personally liable for the company debt.
In simple terms, when you give a personal guarantee, you promise that you take on the responsibility of meeting the obligations of the LLC. Sometimes, this personal guarantee is mentioned in separate paragraphs in the contracts. In some cases, it may take the form of a separate document or an addendum. This is why you should read the contracts carefully before signing. Also, make sure you completely understand the contracts you are signing.
If you sign a personal guarantee, you are signing off the protections offered by the LLC. Signing a personal guarantee makes business sense in certain situations and sometimes, it might be a necessary part of the negotiations but it’s important to take some time and think carefully before signing away your rights.
2. Being Liable for Carelessness or Personal Act
In some situations, there is a possibility that individual members of the LLC are held personally responsible for their carelessness or own actions even when they are acting on behalf of the company. Take the example of a deliveryman getting into an accident and injuring a pedestrian. The court might determine that the accident happened due to reckless driving of the member and they are personally liable for the accident. The court might also find the company liable for the resulting harm.
The reason for personal liability in such cases is due to owners wearing multiple hats. As an LLC owner, you wear the owner hat when dealing with company matters. When you take a personal phone call, you do that wearing a personal hat. You get the idea.
When you are doing something such as operating a machine or driving a vehicle or moving stock or equipment and other such things, you are working individually as well as on behalf of the company. If your actions result in an injury or harm to others, your actions might be used for establishing liability against you individually as well as your business.
3. Taxes Liability
As a member of an LLC, you are personally liable for your own taxes that result from company operations. Members might also be found liable for particular taxes pertaining to the company such as federal and state withholding for employees. It usually happens in cases where members are the persons responsible for control over the company’s money and the ability to repay the company’s debts.
It might seem counterintuitive but you are personally responsible for taxes to be paid by an LLC, in certain cases. It depends on the taxing jurisdiction. In case you are a person responsible for the company’s finances, it may be determined that you are personally liable for taxes.
To keep yourself safe, you should always carry out company transactions properly, record them and make sure all the appropriate taxes are paid to the right authorities within the deadlines. Your job does not end when you remit the payment to the payroll company. You also need to follow up and confirm that the payroll company has done its job and paid the necessary amount of money to the government, on your behalf.
Simply put, when you are the person responsible for managing the finances of an LLC, it may be determined that you have a personal obligation for taking care of the LLC taxes.