Forming a corporate entity is often one of the first items checked off of the to-do list for a new business. Although not essential in every case, creating a corporation or LLC provides a number of benefits to start-up business owners – not least of which is the protection from individual liability for the debts of the company.
Corporate Limitation of Liability
Generally speaking, an entity such as a corporation or LLC shields its owners from personal liability for the business’s debts. For example, if your company defaults on a loan, its creditors can only collect on the assets of the company – not your house, car, or other personal assets. This limitation of personal liability, however, is not absolute. It will not protect you if you personally guaranteed the loan or if your individual actions caused the loss.
The “corporate shield” will also fail if a court decides that the entity should be disregarded. In such a case, the creditor can “pierce the corporate veil” and reach the assets of the individual owners.
Piercing the Corporate Veil
Minnesota courts have laid out the standard under which the corporate veil may be pierced and the corporate limitation of liability disregarded. The determination involves two steps: first, the court looks at how the corporate entity was operated and how much separation existed between the business and the individual owners. Second, the court asks whether there is an “element of injustice or fundamental unfairness” in recognizing the company as a distinct entity.
With regard to the first step, Minnesota courts look for the existence of the following factors:
- Insufficient capitalization for purposes of corporate undertaking
- Failure to observe corporate formalities
- Nonpayment of dividends
- Insolvency of debtor corporation at time of transaction in question
- Siphoning of funds by dominant shareholder
- Lack of function of other officers and directors
- Absence of corporate records
- Existence of corporation as merely a facade for individual dealings
How to Protect against Piercing the Corporate Veil
Due to the subjectivity of the multifactor test described above, it is often hard to predict when exactly the corporate entity will be disregarded and personal liability imposed on shareholders or members. Therefore, best practices for business owners include dotting all i’s and crossing all t’s when it comes to maintaining the company as a distinct legal entity.
This means taking such steps as maintaining separate company bank accounts and filing separate tax returns for the company. Personal assets should never be commingled with those of the business, and company funds should never be put to personal use.
Additionally, business owners should adhere to all the necessary corporate formalities, including shareholder or member meetings and votes whenever required by the bylaws or operating agreement. Proper records should be kept for the company, including meeting minutes and votes and financial records showing the company as a separate legal entity.
