If you’re like most small business owners, chances are you set up your company as either a limited liability company (LLC) or a corporation. You probably did this in part because of the legal protections afforded by LLCs and corporations – under most circumstances, corporate shareholders and LLC members are shielded from personal liability for their company’s debts. By contrast, sole proprietors and partnerships are generally on the hook for their company’s legal obligations. This can lead to devastating consequences, as creditors can go after nearly everything a person owns, including their home. So if your business isn’t set up as either a corporation or an LLC, consider doing so to increase your legal protection.
But even if you’re operating an LLC or corporation, there are rules and formalities you must abide by to preserve your legal protections. Under certain circumstances, courts will “pierce the corporate veil” and hold shareholders and LLC members personally liable for the company’s debts. That is, an act committed by the company will also be attributed to the owner as an individual. The most common reasons courts do this are if recognizing the corporate form would promote injustice, protect fraud, defeat public convenience or a legitimate claim, or defend crime.
There is no bright line test applied by courts in deciding whether to pierce the corporate veil. In Colorado, they consider several factors, including whether:
- the corporation is operated as a distinct business entity,
- assets and funds of the company and the owner are commingled,
- adequate corporate records are maintained,
- the nature and form of the entity's ownership and control lead to misuse by an owner,
- the business is thinly capitalized or poorly funded,
- the corporation is used as a “mere shell,”
- shareholders disregard legal formalities, and
- corporate funds or assets are used for noncorporate purposes. Sheffield Services Co. v. Trowbridge, 211 P.3d 714, 721 (Colo.App. 2009).
- File your annual reports on time with the secretary of state. Small businesses often lose track of this and fall into delinquency. Simplicity Law offers an annual registered agent service that includes taking care of your annual secretary of state filings.
- Keep good corporate records, approve major items and observe all rules set forth in your governing documents (articles of incorporation, bylaws, operating agreement); and hold regularly scheduled board, shareholder and member meetings.
- If your business is an LLC, especially a multi-member LLC, be sure that the members enter into an operating agreement with each other.
- Sign letters, contracts, and other company documents in your capacity as a company representative.
- Avoid mixing your personal assets with those of your company. Maintain a separate company bank account. Also avoid using company funds for activity outside of the company’s core purpose.
- Observe all rules regarding document retention. For example, California requires LLCs are required by law to maintain a specific list of records.