One of the advantages of forming a business as a corporation or a limited liability company is the limitation on liability these business forms offer. Through the limited liability, shareholders and directors are protected from being held personally liable for the debts and obligations of the business. This protection is beneficial, especially when the business does not have enough assets to cover the debt or obligation, and the creditors try to get the money directly from the shareholders and directors.
However, the limited liability offered by corporate formation is not absolute, and in some cases a court may allow a director or shareholder to be held personally liable. This generally happens when the corporation has declared bankruptcy after being sued and being unable to pay the judgment and other business debts. When a court allows the shareholders or directors to be held personally liable for a corporation or a limited liability company, the court is said to pierce the corporate veil.
Piercing the corporate veil occurs in situations in which the shareholders or directors have engaged in some conduct that blurs the lines between the corporation and themselves as separate legal entities. This includes situations in which there is mismanagement by a director with the corporation’s’ funds being intermingled with a director’s personal funds, or in situations in which the corporate formalities required under the law are not followed. In these situations, a court could find that the corporation is nothing more than an instrumentality or an “alter ego” of the director or shareholders, and allow the piercing of the corporate veil.
The corporate veil may also be pierced in situations in which the corporation is found to be underfunded, especially if the underfunding is done intentionally. This can include purposefully taking money or assets from the corporation in order to hide them from future claimants, which may happen in anticipation of the corporation being sued. A court can also pierce the corporate veil if the corporation is used to commit fraud or otherwise commit a wrong.
There are certain steps that directors and shareholders who want to be able to shield themselves from personal liability for the business debts should take. First, they should ensure that the business is properly formed, and all formation requirements are met. Secondly, care should be taken to ensure that the business is following all required business formalities, including keeping proper financial accounting. The business should also have safeguards in place to monitor if a director or anyone else with access is misusing corporate funds for personal use.
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If you are starting a new business, it is important to choose the most advantageous business form for your particular needs. In addition, if you choose to form your business as a corporation or as a limited liability corporation, you must ensure that your business is well formed in order to offer you limited liability protection. For more information on how an experienced business attorney can help you navigate business formation, contact us at Resnick Law, P.C., in Bloomfield Hills and Detroit, Michigan, to schedule a consultation.
(image courtesy of Benjamin Child)