Entrepreneurs often cite the limited liability protection afforded them by way of forming a corporation or a limited liability company as a primary purpose in creating the entity. Sure, there is the aura of sophistication and achievement that comes immediately along with it (as well as several other benefits), but this personal protection seems to be a key factor in most formation decisions.
Limited liability is the concept that the company’s debts and liabilities are its own—an owner of the company is not personally liable for them. This is instrumental in business creation as it allows for a separation between the obligations of the company and the assets of the owners while promoting entrepreneurial risk taking. Generally, if the company fails, only those assets that belong to the company, risk being lost – not the owner’s property. Of course, the homestead may be at risk when the owner uses his or her home as collateral for company obligations. However, there is a lesser known risk to the property under the concept of “piercing the veil.”
Let’s start with an example: New Guy wants to start a business selling widgets. He understands that widgets can be dangerous in some circumstances and does not want his personal assets to be at risk should he be sued. He forms a corporation by filing articles of organization with the state and paying the filing fee, and he is content in his newfound limited liability protection. He then goes out and sells widgets he creates in his basement. New Guy never opens a bank account in the corporation’s name; he deposits his income from widget sales in his personal bank account. He uses the same bank account to pay for his new car. He does not adopt bylaws, keep a corporate record book, have corporate meetings, pay taxes at the corporate level, or note his corporate status on any of his sales documents with his clients. Several months later, a widget he had sold explodes while in use and levels a vacant building. New Guy is upset when he learns of this event and the subsequent lawsuit filed by the building owner, but he feels secure thinking that his new car is not at risk.
While Indiana courts may hesitate to overrule the limited liability protection of corporations and limited liability companies, the courts will “pierce the corporate veil” to prevent fraud and financial injuries to others. Courts examine a variety of factors when deciding to “pierce the corporate veil,” including if the business is undercapitalized or if the business fails to keep records and other company or corporate formalities.
In Fairfield Development, Inc. v. Georgetown Woods Sr. Apartments Ltd. Partnership, 768 N.E.2d 463, 466-74 (Ind. Ct. App. 2002), the court “pierced the corporate veil” holding the directors of Fairfield, the Martz family, personally liable for its debts owed to Georgetown.
One factor affecting the court’s decision was that Fairfield was underfunded; Fairfield received a $2,400,000 construction loan, but they only kept $4,500 in their bank account. The court also noted Fairfield’s general disregard for corporate formalities. Similarly, Fairfield’s office was in a building owned by a director and was the location of various other Martz businesses and Fairfield paid no rent for its office space. Finally, Fairfield did not own any real estate or apartment projects, nor was it constructing any new developments or earning any income from business activity.
In entering the joint venture construction contract with Fairfield, Georgetown relied on the construction experience, resources, financial backing, and personal representations of the Martz family themselves. Weighing the many factors, the court determined that Fairfield was merely the “alter ego” of the Martz family, and held the Martz family personally liable for the debts owed to Georgetown in order to ensure fairness.
A court would apply the same “alter ego” analysis to the New Guy scenario: the lack of corporate documentation, ignoring corporate formalities, and commingling of business funds and personal funds may lead a court to find New Guy personally liable for the damages caused by the exploding widget. Not only could his car be at risk, but also New Guy’s house and savings account.
The act of forming a corporation or limited liability company does not guarantee you the personal protection of limited liability. It is important to follow the formalities that corporations and limited liabilities require in order to be shielded personally by that protection when it may be needed. If the courts determine that these formalities are not being kept or that the corporate form is being abused, they will “pierce the corporate veil” protecting your personal assets. Your house, car, personal bank accounts, and other personal assets will then be at risk to creditors in a law suit or bankruptcy proceeding. Furthermore, the court must be able to clearly determine what belongs to the business and what personally belongs to you. If your personal assets are indistinguishable from the business’s assets, your personal assets cannot be protected from the business’s liabilities.
Some other quick tips to keep the divide between your company obligations and your personal assets:
- All contracts, oral or written, should be in the name of the company, not in any member's or shareholder’s individual name—those signing the contracts should indicate the representative capacity (i.e., sign: John Smith, President). Conduct all business in the company name, not in an individual’s name.
- All income arising from the conduct of the business should be paid directly to the company, and not to any specific shareholder or member.
- All business records should be owned solely by the company and not by any member or shareholder.
- All bank accounts should be in the name of the company, and the company's name should appear on all checks, deposit slips, and other banking transactions.
- Individuals signing company checks should be sure to indicate the representative capacity in which they are signing.
- Checks should be endorsed in the company's name before deposit.
- If the company borrows any money, enters into any lease or any other contract, it should, if at all possible, be done in the name of the company alone and no member should individually sign the contract or guarantee its performance. Under some circumstances, a lender may require you and your spouse, to co-sign or guarantee a company loan, but you should avoid this if at all possible. You are individually liable for any company debts that you personally guarantee.
ABOUT THE AUTHORS – BRIAN CASSERLY & MITCH BRUNO
Brian Casserly is an attorney at Gutwein Law. He received his MBA from Ball State University and graduated from IU McKinney School of Law in 2013. He focuses primarily on business law, non-profit organizations and real estate transactions.
Mitch Bruno was a 2014 summer intern at Gutwein Law and he will be joining us for the summer of 2015 as well. He is currently enrolled at the University of Wisconsin Law School and is scheduled to graduate in 2016.