July 31, 2018 BY Robert Quinn
Piercing the Corporate Veil: How to Ensure Your Business's Debt Does Not Become Your Debt
Many business owners in Georgia create legal entities under which they do business. While some business owners choose to create these entities for tax benefits, what seems to be the chief reason business owners incorporate is to avoid personal liability for their business’s obligations. However, the mere fact that you created a separate corporation or limited liability company (“LLC”) will not always shield your personal assets from a lawsuit against your company.
Recently, we see more and more plaintiff’s attorneys trying to go after the personal assets of the business owners. The process of shifting the business’ liability to the business owner is called “Piercing the Corporate Veil.” In Georgia, if a business owner acts as the “alter ego” of the business entity, a court may disregard the corporate entity and subject the individual owner to personal liability for the debts and obligations of the business. The courts look at a variety of factors to determine whether the business is in fact a separate and distinct legal entity or whether it is merely the “alter ego” of the business owner. In addition to bringing claims to pierce the corporate veil, plaintiffs can now rely on the Georgia Uniform Fraudulent Transfer Act to go after the business owner’s personal assets to satisfy a judgment against the company.
In order to ensure that you do not become subject to a Fraudulent Transfer/Conveyance Action or Piercing the Corporate Veil Claim, you must understand the various factors courts look at to determine whether to hold the business owner personally liable for the debts and obligations of the company. A “fraudulent conveyance” is when a debtor’s attempt to avoid paying an unsecured debt by transferring property or assets to another person or company when the property or assets are at risk to a creditor. Maybe the debtor foresees insolvency and tries to conceal property or assets that a creditor might use to satisfy the debt. Maybe the debtor never intends to pay the debt and transfers property or assets in an effort to become judgment-proof. A fraudulent transfer may be either “intentional” or “constructive.” An intentional fraudulent transfer is a transfer of property made by a debtor to delay, defraud, or hinder creditors. While intent must be determined on a case-by-case basis, a transfer of all of the debtor’s assets to a newly formed company or to a family member to avoid the reach of creditors or litigation is generally considered evidence of intent. In establishing constructive fraud, the debtor’s intent to defraud or harm creditors is immaterial. Instead, the issue is whether the debtor obtained more-or-less equivalent value in exchange for the transfer.
The factors courts look at to determine whether to pierce the corporate veil are similar to the factors considered when determine whether a transfer of assets was “fraudulent.” The essential test for the court is whether the company is treated like the personal assets of the individual or whether the business owner has left the company so undercapitalized that it is essentially judgment proof. The most common factors that courts consider in determining whether to pierce the corporate veil are:
- whether the company engaged in fraudulent behavior;
- whether the company failed to follow corporate formalities; and
- whether the company was adequately capitalized.
The court may first consider whether the company has been actively involved in fraudulent behavior. This may include borrowing money with no intent of ever paying it back or transferring assets out of the company to third parties to make the company judgment proof. Sometimes, it is not absolutely clear that the transfer was fraudulent. However, there are factors the court may consider. For example, if you sell a piece of equipment to well below the market value or sell it to a family member. Or, if you lend money to a third party under suspicious circumstances or without establishing reasonable terms for the loan such as an interest rate of deadline for repayment. Courts have found such conduct as an attempt to defraud creditors, allowing a plaintiff to go after the personal assets of the business owner.
Courts will also look to see if the company follows corporate formalities. Corporate formalities include having annual business meetings or ensuring that you comply with the company’s by-laws or operating agreement. Another corporate formality courts consider is whether business decisions are memorialized in corporate minutes and whether the decision making process complies with the company’s by-laws. The less strict you are in adhering to these corporate formalities, the more likely a court is to find that the business is nothing more than a corporate shell and hold you personally liable for your business’ debt.
In order to avoid a plaintiff seeking to “pierce the corporate veil,” it is essential that you follow these recommendations. First, you must treat the business like a separate and distinct legal entity. The affairs of each owner must be kept separate from the business. If you have not done so already, we recommend having written by-laws or an operating agreement prepared for your company. You should also ensure that your business has a separate Federal Employer Identification Number. In addition, all businesses should have bank accounts separate and distinct from your personal accounts.
Second, you need to ensure that you do not commingle your personal assets with the company’s assets. All too often we see business owners pay for personal expenses with their company’s credit card. Or, on the other hand, business owners will pay company invoices with a personal check. If you cannot show with proper documentation that the expense relates to the business, it should not pay it with company assets. The more the line between personal expenses and business expenses blur, the easier it becomes for a plaintiff to claim that your personal assets are the business’ assets.
Third, maintain business formalities and ensure you document. It's important you comply with the rules governing formation and maintenance of a corporation, including:
- holding annual meetings of directors and shareholders or members
- keeping accurate, detailed records or minutes of important decisions that are made at the meetings
- adopting company bylaws, and
- making sure that officers and agents abide by those bylaws
Finally, ask your attorney to review your business operations to ensure that you have adequately established business formalities to avoid any potential claim to pierce the corporate veil. Often business owners want to avoid the expense of having attorneys perform such an assessment. However, the amount you pay to have an assessment performed may pale in comparison to the amount you spend trying to avoid having debt or judgment attached to your personal assets. If you are interested in having an assessment performed on your company, please contact our firm.
The Journal is a publication for the clients of Drew Eckl & Farnham, LLP. It is written in a general format and is not intended to be legal advice to any specific circumstance. Legal Opinions may vary when based upon subtle factual differences. All rights reserved.
H. Michael Bagley