What is Limited Liability?
Limited liability is one of the cornerstones of American business law. Limited liability means that an owner of a business which is formed as an entity that provides limited liability protection (such as a corporation or a limited liability company) is not personally liable for the business’s debts or its acts. For example, a shareholder does not have to repay a loan the corporation takes out from a bank or pay the damages caused by an automobile accident by one of the corporation’s employees, even if the corporation is unable to repay the loan or pay for the damages. Limited liability is based on the fundamental principle that an entity offering limited liability exists separately and independently from its owners. In the case of a corporation, its shareholders are not liable for the actions of the separate and distinct entity. This principle applies equally to the other forms of business entities that provide limited liability protection, such as limited liability companies and limited liability partnerships.
Do All Businesses Have Limited Liability Protection?
All businesses do not provide their owners with limited liability protection. For example, general partnerships do not provide partners with limited liability. As a result, a partner in a general partnership is personally liable for the partnership’s debts and acts. This is a major reason why most savvy business people avoid creating general partnerships. However, several types of business entities provide limited liability protection, of which limited liability companies and corporations are the most widely used.
What Do Business Owners Need to Worry About?
Even though the business entity chosen by a business owner may provide limited liability protection, courts have recognized a doctrine called “piercing the corporate veil” to bypass that protection. This doctrine allows a business creditor to disregard the separate existence of the business and hold its owners personally liable for the business’s acts or liabilities. Despite its name, the doctrine is not limited solely to corporations, but rather applies equally to all business entities providing limited liability protection.
When Will a Court Pierce the Corporate Veil?
Generally, courts will pierce the corporate veil only in situations where the owners do not operate the business like it is a true and distinct entity separate from the owners themselves. In North Carolina, courts have pierced the corporate veil and held a business’s owners personally liable for the business’s liabilities and acts when the business is found to be the “alter ego” of its owners or is operated as a “mere instrumentality” of its owners. While courts analyze each situation on a case-by-case basis, the theme remains the same: if the owners are operating their business merely as an extension of themselves, rather than as a truly separate entity, the courts will pierce the corporate veil and hold the owners personally liable for the business’s liabilities and acts. The following factors are commonly found in cases where the courts have pierced the corporate veil:
- Inadequate Capitalization of the Business: Courts are more likely to pierce the corporate veil if the owners intentionally maintain an insufficient amount of capital to pay the business’s debts. When determining whether a business is adequately capitalized, a court will consider how long the business has been in existence, its size, and its industry. While courts will look at the historical and overall levels of capitalization of a business, the emphasis is on whether the business is intentionally undercapitalized. Since many early-stage companies are naturally undercapitalized, undercapitalization itself will not cause a court to pierce the corporate veil. In fact, intentional undercapitalization is a difficult fact to prove, unless the undercapitalization can be linked to a clear business decision made for the purpose of avoiding payment of the business’s liabilities. For example, if it can be shown that an established and profitable trucking company purposely maintains very little capital so that the business is not able to pay victims who suffer injuries in accidents involving its trucks, intentional undercapitalization may exist and the corporate veil may be pierced.
- Failure to Operate the Business as a Distinct Entity: A court is more likely to pierce the corporate veil if the business is not operated as an entity that is distinct from its owners. Therefore, owners should not mix the operation of the business with the conduct of their personal affairs. For example, owners should not maintain a single bank account for both personal and business funds and should operate their business in a manner that indicates to third parties that they are dealing with a business rather than its owners. The easiest and most practical way to maintain a separate existence is for the owner to sign all business-related agreements or documents on behalf of the business (e.g., John Doe, President of ABC Corporation), rather than signing the documents in an individual capacity (e.g., John Doe). Owners also should be diligent in honoring the proper procedures and formalities for operating a business entity such as having a board of directors; naming necessary corporate officers such as a president (or manager for a limited liability company), a secretary, and a treasurer, even if only one or two persons fill all of the positions. Minutes and resolutions authorizing important business decisions should be made and maintained separately from the owners’ personal records.
Generally, no one factor is sufficient for a court to pierce the corporate veil, but a single factor could be sufficient if the case was extreme.
Preserving the Limited Liability Protection of Your Business
Most of the ideas expressed in this article are fairly straightforward and common sense. If your business is intentionally undercapitalized, if you commingle your personal and business funds, if you operate your business in a manner whereby the average person does not know whether the person is dealing with you personally or with your business, or if you do not diligently honor the proper procedures and formalities for operating a separate business entity, then you are not respecting the business’s separate existence, and a court may pierce the corporate veil and hold you personally liable for the business’s actions. Long story short: if you operate your business in a reasonable and business-like manner, you should continue to enjoy the protections of limited liability.
For further information regarding the issues described above, please contact Lee C. Hodge .
