When shareholders invest into a corporation, there is an expectation of limited losses amounting to the financial investment made. However, if the company is not properly run, officers, directors and shareholders are exposed to the blade of the law. This is known as piercing the corporate veil. Therefore it is critical for any shareholder, director, or officer of a small corporation to understand what is required to protect your personal assets from exposure to creditors and the long arm of the government.
This article has a summation section at the beginning and a more detailed analysis of the do’s and don’ts of proper corporate management in the in-depth section. I am not an attorney and if your company is being pursued by creditors or the government, I strongly encourage you to seek counsel. I am not from the current 20 year old generation that thinks there is some kind of quick solution to every problem. Running a business requires knowledge and good information. Therefore the detailed sections below are lengthy and designed to educate the small business entrepreneur in proper corporate management thus helping to shield the officers, directors and shareholder(s) from the creditor’s blade.
To pierce the corporate veil, creditors or the government look for one of two scenarios to prove that the business acted outside of the corporate protection provided by the state. The following is a brief description of the two scenarios:
No separation of the officers/directors/shareholder(s) from the corporation – essentially the corporation is a mere piece of paper and the management team failed or poorly operated the company as a true corporation and managed the business more as a sole proprietorship or partnership. The following are examples of poor corporate management:
- Paying of personal expenses from the corporate checkbook
- Failure to conduct proper corporate meetings including lack of minutes and state corporate records
- Misunderstandings of the business status with customers, vendors, suppliers or employees
- Non or poor compliance with governmental authorities
- Inadequate accounting records or the lack of reasonable financial statements
Fraudulent activities – the management team conducted the business in an unreasonable fashion or in an illegal way. This often boarders on the criminal activity level of conducting business. Examples include:
- Misleading or misguiding creditors in the application process or during the repayment process
- Poorly capitalizing the corporation; shareholder(s) lending money to the business instead of the traditional stock purchase placing the shareholder(s) ahead of other creditors in the payback process
- Reckless spending or financial activity that directly benefits the management or shareholder(s) over vendors, suppliers, and employees
- Failure to insure the business or the operation is under insured
Detailed In-Depth Analysis of Piercing the Corporate Veil
There are several reasons an opposing party desires to pierce the corporate veil or shield in business. Often the officers, directors and shareholder(s) of a small business operation have more financial wealth to access than the company maintains. So creditors and the government seek to pierce the corporate veil to gain access to the owners and obtain a higher level of financial reimbursement for a wrong.
For owners, incorporation provides protection from opposing parties. The six primary reasons to incorporate include the following:
- Separate taxation
- Right to own property
- Right to sue and be sued in the state’s district and circuit courts
- Right to petition the local and state government for laws and regulation modifications
- Due Process
See: Why Incorporate? for more information about why owners incorporate their business.
When a business incorporates it becomes a new entity recognized by the state and the federal government. As an owner you must operate the business as a true separate entity. Failure to demonstrate activity as a separate entity lowers the veil and the owner is no longer protected under the law. So how does an owner demonstrate true separation? There are several courts cases used to identify the required elements of proper separation. They include:
Multimedia Publishing of S.C., Inc., 314S.C. at 553, 431S.E.2d at 571
- University Medical Associates of Medical University of S.C. v. UnumProvident Corp., 335F.Supp. 2d702, 707
- Sturkie, 280 S.C. at 457, 313 S.E.2d at 318
The following is a list of required actions to demonstrate and document true separation. It starts from the more generic to the specifics of true separation.
The most important step in validating the existence of the business is to incorporate. This is a state level requirement usually conducted via the State Corporation Commission or the Secretary of the State. The state grants permission to exist as a corporation with a certain name. During this process the state wants to know who the directors and officers are and who the registered agent is (where to mail the notifications). In general, the corporation must file an annual report and pay a fee to exist. The annual report is merely a document identifying the officers and directors and their corresponding addresses.
To comply with the law, each year the company should conduct a corporate meeting of all directors and shareholders for the purpose of electing or replacing directors. There is a hierarchy of ownership and management in a business. It should flow like the following table:
Shareholders are provided notice at least two weeks in advance of the annual meeting. The shareholders are responsible to elect directors and approve of resolutions (borrowing money, buying other businesses, or creating a partnership with another business entity).
Directors are most commonly the owners or shareholders of the business. In general they have more invested in the operation and desire to protect that investment. Therefore they vote for themselves as a director. Once a board of directors is elected, the board meets to hire or elect officers that will run the company.
Officers are hired to run the business. They make the day to day decisions and should report to the board of directors frequently to demonstrate proper corporate activity. Usually this reporting process is quarterly via write-ups of activities and reporting of financial information. In general the officers hire and fire staff, make arrangements for operations from signing leases to interactions with the government and the bank.
During the initial meeting of the shareholders, a set of by-laws is approved. These by-laws identify the respective responsibilities of the directors and officers. In addition the by-laws outline the annual calendar of compliance requirements: 1) Corporate Filings, 2) Corporate Meetings, 3) Legal Compliance, and other forms of date driven requirements to maintain corporate existence.
In most small business situations, there is one shareholder and thus this shareholder is not only the sole director, but he is the sole officer too. He still needs to document meetings and the election of the director and officer. There should be minutes of these meetings. Minutes are merely short statements of fact or activity conducted at the meeting. The minutes identify who attended, issues voted upon, how each member voted and of course the time and place of the meeting.
All documents should be stored in a corporate book with an electronic copy of the documents in the corporate file. Read the legal and taxes section of Create a File Structure for Accounting for where to store the electronic documents.
It is important to identify the limitations of the officer’s job in the by-laws. There should not be absolute power granted to an officer of the company. Certain issues should be voted upon by the directors and higher level issues should be controlled by the shareholders. The following are examples of these limits:
Depending on the size and nature of the business, officers should be limited to around $10,000 as the borrowing limit they may authorize for vendor accounts or short term notes from a bank. Directors should control borrowing in excess of $10,000 up to $50,000. Any long term notes or borrowing in excess of $50,000 requires shareholder approval.
This should not be a blanket format, use some reasonable thinking in this. If your business is buying and reselling large ticket items, then change the dollar amount to a reasonable level. As an owner you don’t want to have to go through some formal process to authorize the purchase of inventory in the auto industry or for diamonds in the jewelry business. So carve out exceptions as it relates to inventory items for day to day operations.
The by-laws should create a separation of responsibility as it relates to hiring and firing of personnel. The board of directors should be responsible to hire and fire any officer of the company. Officers include:
However, the board should use its discretion to determine if the secondary tier of managers is controlled by the board or the by the President of the company. Examples of these positions include branch managers, plant managers; directors of operation, personnel and finance. The President should have sole discretion to hire and fire any position lower than this second tier of management.
The President or any officer should not have the authority to enter into agreements or change the overall operations of the company. Only the Board of Directors should authorize expansion of plant facilities, product lines, mergers, partnerships with other businesses and issues concerning the brand, logo or trade-marks.
Real Estate/Long-Term Leases
Long-term leases and issues concerning real estate is a board issue and not a power held by the President or any officer. Separating this responsibility from the officers demonstrates good management and provides evidence of operating the company as a true separate and distinct entity.
All legal and accounting services (Audit and Consulting) should a power held by the Board of Directors and separated from the duties of the officers of the company.
Note how important it is to truly separate the duties of the company to match more closely how large publicly traded companies act. When an opposing party seeks to pierce the corporate veil, one of the primary goals is to demonstrate that your company is a ‘Defective Corporation’. The opposing party tries to discover evidence that you failed to properly document and comply with state laws as corporations should. In addition, the opposing party will seek to prove that you did not separate the duties and responsibilities. By keeping a set of by-laws, conducting regular meetings, and complying with government deadlines a small business entity can demonstrate proper corporate management.
If you are a small business operation, less than $2,000,000 in revenue or less than 10 personnel in the company; it is not uncommon for one person to perform all of the officer and board duties. Generally these are considered tightly held business operations whereby one or two individuals own the company and use the corporate status to minimize taxes and creditor liabilities. To demonstrate proper corporate management, the key is to document critical decisions and stay in compliance with governmental deadlines. In addition, you still need a set of by-laws but identify in those by-laws points of duty shifting as ownership and capital investment increase. Below is an example of the change in the Board of Directors membership as the company changes in ownership:
The Board of Director(s) count shall match the number of shareholders for all odd shareholders up to and including five shareholders. For an even number of shareholders up to and including four, an additional director will be appointed as agreed upon between the existing shareholders. This additional director should be the company’s attorney, accountant, or some other knowledgeable individual in this field of business. The following is the schedule of directors based on the number of shareholders up to five shareholders:
One Shareholder – One Director
Two Shareholders – Three Directors, two elected by the shareholders and one appointed by the two shareholders.
Three Shareholders – Three Directors, all elected by the shareholders
Four Shareholders – Five Directors, four elected by the shareholders and one appointed by the four shareholders.
Five Shareholders – Five Directors, all elected by the shareholders
In addition, as the company continues to expand, rewrite the by-laws to more closely match the illustration in the corporate management illustration above.
Although highly argumentative, this is one of the easier elements to prove when an opposing party needs to demonstrate a lack of separation between the owners and the company. The simplest way is to review the balance sheet and point out the shareholder loans to the company. Often small businesses borrow money from the shareholders. If this borrowing extends beyond a reasonable period of time, a creditor can show that the owner had limited his risk to the detriment of the other creditors. So it is important to limit shareholder loans to a short period of time or to insignificant amounts.
Other ways creditors can prove lack or improper capitalization is based on the industry standards commonly available. If the business operation requires the use of expensive fixed assets such as a site developer or road contractor and the company uses very little shareholder investment to purchase these assets, then the corporate veil can be easily pierced. There is no correct amount or percentage, but the key is to compare your operations to others in the same industry and point out any lack of capital investment as an indicator of separation between the owner and the company.
At the other end of the spectrum, some personal service based operations with good and regular cash flow can be thinly capitalized especially if very little use of creditors is required in day to day operations.
The opposing party only needs to compare your business to the industry standards to discover improper capitalization.
Separation of the Financial Elements of Corporation and the Owner(s)
Creditors often look to the use of company funds to pay personal expenses of the owner(s) as evidence of improper corporate conduct. So the best method to eliminate this possible factor is separating the owner from the corporation. The following is a suggested list of methods to distinguish true separation of the owner(s) from the business operation:
A separate bank account for the company
- Do not pay personal bills of the owner(s); instead make a distribution or dividend payment when the owner(s) are in need of money or desire to take profits
- Life insurance premiums on owners can be paid provided that the owner(s) are actively participating in the company’s day-to-day operations. It can be further substantiated as evidence if the owner(s) are key individuals in the operation of the business. Examples include carrying the professional license like a doctor or engineer; trade secrets are titled to the owner(s); or the overall knowledge and relationship with customers are essential for the success of the company
- Do not allow unreasonable expenditures to favor the owner(s); this is most commonly found in travel especially to exotic destinations
- Owner(s) should reimburse the company for personal use of corporate assets such as cars and phones when these assets are used for personal purposes. An example is when an owner of a construction company uses a backhoe to dig a hole for his personal pool. He should reimburse the company a reasonable hourly charge for the backhoe’s use.
- Health insurance premiums paid on behalf of the owners should not be greater than those paid on behalf of other employees
Failure to timely file and report income and expenses in accordance with local, regional, state and federal law can provide evidence of the lack of separation between the shareholder(s) and the company. In general, this by itself is not grounds to pierce the corporate veil. However, it can help to substantiate the position taken by opposing parties as to the lack of maintaining proper corporate existence. In general, in most civil cases, it is the preponderance of the evidence that will remove the shield of protection for the shareholder(s)/owner(s).
This is the most common method for creditors or the government to pierce the corporate veil. There is case after case of examples of the owner(s) or shareholder(s) conducting fraudulent and even criminal activity within the confines of the corporation. The owner(s) or shareholder(s) believe the corporate veil (shield) will protect them and it does not.
The most common form of fraud is the outright misleading of creditors in the application process. If false or embellished information is provided to creditors and creditors rely on that information to make a decision in the corporation’s favor, then creditors have a right to pursue the perpetrators of the fraud. This is most often the corporate officer(s) usually the owner(s) and primary shareholder(s).
In modern banking, loans for small businesses are commonly guaranteed by the primary shareholder(s). This is the tool banks use to sidestep the issue of fraudulent information. By subjecting the shareholder(s) to personal liability, there is no need to pursue piercing the corporate veil to get access to the shareholder(s). They already have it via a signed guarantee. Many large corporations that extend credit use the personal guarantee as a method to alleviate this concern.
In the professional world, any fraudulent act automatically causes personal liability to the professional involved. Thus this individual is automatically exposed for personal liability for such acts and the corporate veil has no value to protect this professional.
There are so many cases of fraudulent acts that allow the piercing of the corporate veil that is best for the reader to understand that any misleading or negligent act automatically opens this officer, director and/or shareholder to liability. It is in your best interest to conduct business activities in a positive and straight forward format. Make sure that this form of activity is instilled into the culture of the company. In effect, make it a part of the policy of the company to conduct business in a straight forward and professional manner.
The Small Stuff
There are some minor items the officers/directors/shareholder(s) need to remember too:
Maintain adequate insurance – make sure the company is properly insured. This includes professional liability, general liability, property, workman’s compensation, auto, product, bonding, revenue losses, and an umbrella policy.
- Proper signature – when signing legal documents, sign as the officer or director and not as an individual. If the title is not there, insert it on your own. Do not sign documents in your own name; sign them as President, Director, or whatever position you currently hold.
- If you use a trading or doing business as (DBA) then send notice to your local circuit court and to the secretary of your state of this pseudo name. This gives notice to all parties that your ‘Also Known As’, AKA is equal to your corporate name.
- Educate your staff to help protect you. This should be a regular calendar item. Educate staff on proper interaction with customers, vendors, suppliers and outside entities so that those not employed in the company know who you legally are and how you conduct business.
- Maintain good accounting and legal records
Overall, this may seem exhausting but in reality, there is case after case of how individuals have pierced the corporate veil over many years. The most common way is due to fraudulent acts or gross negligence on behalf of officers, directors and shareholder(s). There is substantial case law illustrating how self-dealing in business pierces the veil too. A shareholder/owner of a small business needs to maintain proper corporate formalities, capitalize the business appropriately, separate the financial transactions of the company from his/her personal transactions, comply with the law for reporting and paying taxes, and finally staying true to the law in conducting business. By doing the above, the owner/shareholder need not worry about an opposing party piercing the corporate veil and going after you as an individual. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.