Starting A Small Business: Limiting Owner Liabilty Behind the Corporate Veil

One of the major reasons companies choose to form a legal entity (such as an LLC or corporation) is to limit personal liability of the shareholders or members.  Simply put, the personal assets of the company’s owner(s) – including their homes, cars, savings, and personal property – are not at risk for actions taken by the company when the company is a limited liability legal entity.  This limited liability is typically referred to as the “corporate veil” because the owners of the company are protected behind it.  It is very important, though, for business owners to understand that there are situations where the corporate veil can be “pierced” to reach the personal assets of the business owners.

The Corporate Veil in Ohio and Michigan

In Ohio, the corporate veil may be pierced (and the owners can be held personally liable) if the following three things are all true:

  1. control over the corporation by those to be held liable is so complete that the corporation has no separate mind, will, or existence of its own
  2. control of the entity is used to commit fraud or wrong or other dishonest or unjust act; and
  3. injury or unjust loss resulted to the plaintiff from such control and wrong.[1]

In Michigan, the following three things must be proven to pierce the corporate veil:

  1. the corporate entity must be a mere instrumentality of another entity or individual,
  2. the corporate entity must be used to commit a fraud or wrong
  3. there must have been an unjust loss or injury to the plaintiff. [2]

How to Avoid Piercing the Corporate Veil

Taking these tests into consideration, here are some steps to take to avoid personal liability arising from your limited liability business:

  • open up a separate business banking account
  • obtain a federal tax ID number for your business
  • maintain corporate formalities
  • have an operating agreement drafted for your business
  • either have enough money in your bank account to cover expected liabilities for the business or take out an insurance policy to cover expected liabilities for the business
  • keep formal meeting minutes for your company
  • maintain corporate records
  • hold at least one meeting per year, even if you are a single member LLC (Dahman Law can serve as the meeting secretary and assist in keeping your corporate records)
  • do not use include personal expenses in those of the business
  • do not comingle personal assets with those of the business
  • do not commit fraud

Starting a Small Business: Does my LLC Need an Operating Agreement?

An Operating Agreement is an agreement among the members of a limited liability company (an “LLC”) which governs how the LLC will operate.  It also contains general procedures as well as member’s financial and managerial rights and duties.

In Ohio, LLCs are governed by the default rules set forth Ohio Revised Code Chapter 1705.  In Michigan, the applicable rules are found in MCL 450.4101 et seq.  Operating Agreements help you guard your limited liability status, head off financial and management disputes, and ensure that your business is governed by your own rules rather than your state’s default rules.  Thus, it is strongly recommended that your LLC have one.  Here are a few of their main benefits:

  1. Operating Agreements protect your LLC’s limited liability status.  In single member LLCs, an operating agreement is a declaration of the structure that the member has chosen for the company and sometimes used to prove (in court or with the IRS) that the LLC structure is separate from that of the individual owner.  An Operating Agreement is necessary documentation that the owner is separate from the entity itself.  In fact, many states, including Michigan, have laws saying that an operating agreement for a single-member LLC is not invalid simply because only one individual signed the document.
  2. Operating Agreements define the LLC’s financial and management structure.  It is essential for multi-member LLCs to document their profit-sharing and decision-making protocols as well as their procedures for handling the additions of and departure of members.  Without an Operating Agreement, even the smallest financial and managerial disputes can cripple your LLC.
  3. Operating Agreements override default rules imposed by a state’s LLC Act.  In order to do so, an Operating Agreement generally addresses the following things:  the initial members of the LLC; the members’ percentage interests in the business; the allocation of profits and losses among members; the capital contributions of members; the members’ voting power; and rules for holding meetings and taking votes; and “buy-sell” provisions, which set out rules for what to do when a member wants to sell his or her interest, dies, or becomes disabled.

This internal agreement, which is agreed upon by the company members, contains provisions for critical rules and provisions relating to how the company is run.  So if you live in Ohio or Michigan and have an LLC, it would be foolish not to protect yourself and your business with an Operating Agreement.

Starting a Small Business: What is the Difference Between an LLC and a Corporation?

A common first question for small owners is whether to incorporate as an LLC or a corporation.  While the two entities are similar in many ways, they also have several differences.  LLCs, as opposed to corporations, combine the personal liability protection of a corporation with the tax benefits and simplicity of a partnership.  Also, corporations can elect to be taxed as an S corporation.  S corporation status provides many of the benefits of partnership taxation, but there are certain restrictions.  There are benefits to both entity structures, but personal liability protection is basically the same for both, so your decision to form a corporation or an LLC should not hinge on the asset protection issue.  Consequently, which entity is best for you will depend on your businesses’ individual needs and circumstance.

Advantages of a Corporation

Here are four principal advantages to forming a corporation rather than an LLC:

Corporation profits are not subject to self-employment taxes.  Salaries and profits of an LLC are subject to Medicare, Social Security, and certain other taxes.  In the case of a corporation, though, only salaries (not profits) are subject to such taxes.

Corporations are able to offer a greater variety of fringe benefits.  In fact, various retirement, stock option and employee stock purchase plans are available only for corporations.

Judicial treatment of corporations is more predictable.  Unlike corporations that have been around for a long time, LLCs are a relatively new legal creature and still being tested by courts.  Furthermore, some states place restrictions on the type of business conducted by an LLC.  For Ohio LLC restrictions and rules, see the Ohio Revised Code, Chapter 1705.

Transfer of ownership is easy for corporation.  Corporation stock is freely transferable, as long as IRS ownership restrictions are met.  LLC membership interest (ownership) typically is not freely transferable – approval from other members is often required.

Advantages of an LLC

Here are four main advantages to forming an LLC rather than a corporation:

There are fewer corporate formalities with LLCs.  Corporations have a relatively detailed list of things that need to be done in order to insure the courts will “respect” the corporate structure and liability shield.  For example, corporations must hold regular meetings of the board of directors and shareholders and they must keep written corporate minutes.  Conversely, members and managers of an LLC are not required to hold such meetings.

LLCs have no ownership restrictions.  S corporations, for example, cannot have more than 100 stockholders.  Also, each stockholder in an S corporation must be a U.S. resident or citizen. S corporations cannot be owned by C corporations, other S corporations, LLCs, partnerships or many trusts.  These restrictions do not apply to LLCs (or C corporations).  And LLCs are allowed to have subsidiaries without restriction.

LLCs have greater tax flexibility.  LLCs are treated as a “pass-through” entity for tax purposes.  In fact, LLCs can elect to be taxed as either a C corporation or an S corporation.

LLCs have the ability to deduct certain losses.  Members who are active participants in an LLC’s business can deduct operating losses against their regular income to the extent permitted by law.  But taxes issues are usually not a legal question.  They are an accounting question, so please consult your tax planner also.

Starting a Small Business – Why Incorporate?

There are many reasons business owners choose to form a legal entity – whether a limited liability company, corporation, S-corporation or otherwise.  The most important reason is that forming a legal entity reduces personal liability.  Forming a legal entity also adds credibility and permits the business to grow.  Plus, a legal entity permits the business to build its own credit.  And ownership in the entity can be more easily transferred.

Limit Personal Liability.  First, and foremost, forming a legal entity shields the owner(s) from personal liability for debts of the business and lawsuits against the company.  So the existence of a legal entity protects the your personal assets such as your home, car, possessions, and savings.  It does not, however, shield you against personal torts (injuries) that the owner commits on behalf of the entity.  This limited liability is often referred to as the “corporate veil” because the owners of the company are protected behind it.  It is very important, though, for business owners to understand that there are some limited situations where the corporate veil can be pierced to reach the personal assets of the business owners, such as where the owner co-mingles assets or does not abide by corporate formalities.

Grow Your Business, Now and Later.  Second, forming a legal entity adds credibility to the business.  Forming a legal entity communicates not only credibility but also permanence and prestige.  The credibility that comes with forming a legal entity can also help your new business with potential customers, employees, vendors and partners.  At the same time, it informs those same people that they are dealing with an entity and not you personally.

Build Buiness Credit.  Third, because a legal entity – whether corporation or an LLC – is a separate entity, you are able to establish both a new and separate credit profile completely distinct from your own personal credit profile.  Being able to establish business credit is especially advantageous for those who may have poor personal credit because it enables you to build a clear credit profile for the business.  As a result, you may be able to receive loans, credit cards and credit lines that you might not be able to obtain as an individual, and eventually at better interest rates.

Transfer of Ownership.  Corporation ownership can be easily transferable (with some restrictions on S corporations).  Capital can be raised more easily through the sale of stock.  Another advantage is that many banks prefer handling loans with incorporated borrowers.  And while you can’t live forever—your corporation can.  Even if an owner dies or sells interest, the corporation still exists.