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.
Following the precedent set in Aronson v. Price, 644 N.E.2d 864, 867 (Ind. 1994), recently the Indiana Court of Appeals in Blackwell v. Superior Safe Rooms LLC, 174 N.E.3d (Ind. Ct. App. July 7, 2021) retroactively “pierced the corporate veil” holding the owners of Superior Safe Rooms and Wharff Excavating personally liable for a $161,625 judgment.
One factor affecting the court’s decision was that Superior Safe Rooms was underfunded. Superior’s bank account contained $300, not nearly enough to cover a potential claim. The court also noted Superior’s general disregard for corporate formalities. The court noted that Superior did not have tax records, employee/payroll records, balance sheets, or other common business records. Superior had no physical place of business or equipment, and no employees.
In entering the contract to construct the safe room, the plaintiff became aware that Wharff Excavating would be completing the construction. The construction was never completed, and the plaintiff was left to sue an insolvent corporation. However, because of the “alter ego” theory under the principal of “piercing the corporate veil” the plaintiff was able to hold Wharff Excavating liable, and the owner of Wharff Excavating personally liable for the debts owed.
The court noted, that although Superior and Wharff Excavating did not use “similar corporate names,” they did share employees and officers, business addresses, emails, and had similar business purposes. Superior was merely an entity used by Wharff Excavating to get business. Not following corporate formalities was a catastrophic loss to all the defendants.
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 lawsuit 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.
Questions about protecting your personal assets with a corporation or LLC? Give us a call at 765.423.7900 or send us an email at firstname.lastname@example.org.