Observing corporate formalities (avoid getting personally sued)
Most business owners who have a corporation or LLC (hereinafter referred to as a “company”) understand the basic legal concept of why they run their business out of a company. Setting aside the issue of tax benefits that may be gained, the primary legal reason you conduct your business through a company is so that if there is ever any liability incurred to the business that liability will attach to the company and not to the individual person who owns the company. However, understanding this concept is not enough, and setting up a company is not enough. To effectively protect against personal liability, the business owner must properly use the company.
When a plaintiff is allowed to sue the owner of a corporation, instead of (or in addition to) suing only the corporation itself, attorneys call that “piercing the corporate veil.” If the business owner properly sets everything up in the company name, then piercing the corporate veil is very difficult.
Let’s suppose that John Smith is the sole owner of Smith Retail, Inc., which sells widgets out of a small gift store in a shopping mall. One day an angry client files a lawsuit against John Smith, individually, claiming that the widgets he purchased were defective. Mr. Smith’s first obvious questions will be “why is the plaintiff suing me?” and “aren’t they only allowed to sue my company?” In other words, can this plaintiff ‘pierce the corporate veil’? Mr. Smith’s attorney will also ask the judge the same questions, hoping that the case against Mr. Smith is dropped, and that the plaintiff only be allowed to sue Smith Retail, Inc.
Before the judge will make that determination, however, he will ask Mr. Smith to prove that his widget business is actually being operated through Smith Retail, Inc., and not through Mr. Smith personally as a sole proprietor. That analysis will include the following questions:
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- Is there, in fact, a corporation called Smith Retail, Inc.? Is it in good standing with the Virginia State Corporation Commission? If Mr. Smith has let his corporate entity lapse, and it is not in good standing, then this improves the argument of the plaintiff that the business is not legitimately being run through a corporation.
- The business operates out of a leased space in the shopping mall….is that a lease between the Landlord and John Smith? Or between the Landlord and Smith Retail, Inc.?
- The business must be operating under a business license issued by the local city/county…..is that business license issued to “John Smith d/b/a Smith Retail?” or is it issued to “Smith Retail, Inc.?”
- Is the business bank account in the name of John Smith? Or in the name of Smith Retail, Inc.? Are the employees being paid from a bank account of the company? or from funds of John Smith personally?
- To whom is the Federal Tax ID Number (also known as an EIN) of the business issued? To John Smith? or to Smith Retail, Inc.?
- In whose name are all of the utility accounts (i.e., water, electrical, etc.) of the store? In the name of John Smith? Or Smith Retail, Inc.?