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New Business Formation - Avoiding Personal Liability

May 04, 2018

By: Barry Dorans

A primary reason why an owner retains a lawyer to help them set up a business is to make sure they are not personally liable for the debts of the company. A recent case from the United States Fourth Circuit Court of Appeals explains that not only do you need to have the documents prepared correctly, but you also need to follow certain rules to keep that protection in place.

Starting with the basics, if you operate your business without setting up a corporate entity, such as a limited liability company or corporation, then you are personally liable for any claims against the business. If an owner properly sets up a limited liability company or corporation, then they are not personally liable for most of the claims against the company. However, that shield is lost if the owner fails to do certain things correctly.

In particular, a creditor many “pierce the corporate veil” and require the business owner to be responsible for a debt of the company if the business owner violated certain rules in operating the company. Typical examples are when the owner uses the company to pay his own personal obligations, such as tuition for his children, etc. instead of taking a draw or salary and then paying the tuition from his own funds. In Sky Cable, LLC v. Coley (4th Cir. Court of Appels), a variation of the piercing the veil argument was made.

In that case, Sky Cable, LLC obtained a multi-million dollar judgment against Mr. Coley. They tried to collect on that judgment, but they were unsuccessful because Mr. Coley owned nothing in his name. However, he had sole ownership of several limited liability companies. Sky Cable, LLC then attempted to reverse pierce the corporate veil and have the judgment against Mr. Coley individually turned into a judgment against the limited liability companies. Even though the limited liability companies were completely unrelated to the claims that were made by Sky Cable, LLC, the Court held that each of the three limited liability companies were also liable for the judgment.

The Court found that Mr. Coley treated each of the limited liability companies as his own alter ego, meaning he used them for his own personal benefit. Importantly, the Court did not hold that Mr. Coley had a fraudulent intent when he established the limited liability companies. Instead, the Court held that they failed to follow corporate formalities when doing business with one another. In particular, Mr. Coley failed to keep records of how and why funds were transferred from one company to another or into his own personal accounts or why the mortgage on his personal residence was paid by the one of the companies. The Court found it would be an injustice to allow Mr. Coley to stand behind the corporate shield and accordingly allowed the judgment to be imposed directly against the companies. While this case dealt with a reverse corporate veil piercing, if Sky Cable, LLC had first obtained a judgment against one of the limited liability companies, it would likely have been able to pierce the veil and impose the judgment on Mr. Coley personally due to his failure to observe corporate formalities.

The takeaway is that when setting up a corporate entity, you need to have the proper paperwork prepared at the outset to limit the personal liability of the owner for claims against the company. Even if that is done correctly, the owner still needs to abide by corporate formalities to make sure that shield is not lost. That is why an owner should consult with an attorney when setting up a company to learn the rules that need to be observed to keep the corporate shield intact.

If you have any questions, please contact an attorney to avoid losing this important shield.