Sometimes in business, things don’t go as planned. You may spend years building something great, only to have a change in the economy or competitive environment put you out of business. At that point, there is a chance you may not be able to pay back all of your creditors and they will not be happy about it.
In fact, they may try to figure out a way to “pierce the corporate veil” and find you personally liable for the debts so that they can go after your personal assets to make themselves whole.
Many people falsely assume that if they set up a corporation or LLC that their personal assets are always out of reach of a creditor or plaintiff in a lawsuit, but, depending upon the state you are in and the particular circumstances of the case, your personal assets could be used to settle a debt or legal action.
Here are 5 circumstances in which your personal assets could be at risk:
1)When the LLC or Corporation is just an “alter ego” for the owners
In some cases, business owners don’t maintain adequate separation between their business and personal affairs and the LLC or corporation is really just their “alter ego.” Examples of this might be an owner paying personal bills from a business checking account or using business equipment or property for personal use.
2)When the company is not adequately capitalized
If the company does not have its own bank account with enough money to cover operating expenses, it could be seen as failing to have adequate capitalization. For example, if a business can not yet support itself based on profits and foresees $1 million in expenses in the coming year, only putting $100,000 into the company is likely setting it up for failure.
3)When corporate formalities are not followed
“Corporate formalities” are important actions for a business to take to ensure that the company remains legally separate from its owners. Failure to maintain these formalities could result in a plaintiff or creditor successfully piercing the corporate veil. Although these differ between corporations and LLCs, some formalities may include items such as 1) taking care of proper filings and taxes, 2) having an operating agreement which defines business rules and member roles and 3) holding regular member meetings and keeping minutes.
4)When a subsidiary is not a truly separate entity from its parent
In the same way that it is important for a company to not be an alter ego of its members, it’s also important for a subsidiary to not be an alter ego of its parent company. For example, it might help a creditor make an alter ego case if both parent and subsidiary share the same office, bank accounts, employees, etc.
5)When the company engages in fraud or wrongdoing
If a company engages in illegal activity for the benefit of its owners, the limited liability status of that company could be ignored by the courts. Also, if a company recklessly incurs debts that it knows it can’t pay back, a court could find that financial fraud was committed and pierce the corporate veil at that point.
Ultimately, the law around this subject is complicated and can vary quite a bit based on circumstance or the state you are in. We at MoneyCentro are not lawyers and this article contains general legal information rather than legal advice.
To truly understand if you are at risk and how to best protect yourself, it’s advisable to speak with an attorney. While usual attorney fees can be expensive, an online legal service such as Nolo.com can offer more affordable options.