Take care to avoid liability traps

Nation's Business, Nov, 1997 by Anthony J. Mohr

One of the most important reasons that business owners choose to operate their companies as corporations is to protect themselves against personal liability for business debts and court judgments. Most owners who incorporate believe that their homes, bank accounts, and other personal assets are safe; in practice, however, incorporating does not confer automatic protection.

If the principals do not incorporate properly or if they commingle business and personal assets, they risk personal exposure.

Shareholders and directors also may be held liable if they intended to defraud creditors or if "there is no real attempt to respect the corporate enterprise," says Joseph Fleischman, a Roseland, N.J., lawyer who has dealt with such issues.

Even directors who were not personally involved in questionable company decisions are not immune from liability. If a director knew or should have known about questionable dealings, his or her personal wealth may be at risk.

No single fact determines when a court will, metaphorically, "pierce the corporate veil" and hold owners and directors personally liable. The fundamental question is whether the corporate shield is being used to protect someone engaged in fraud or other wrongdoing.

In attempting to answer that question, most judges refer to more than two dozen factors that indicate various kinds of inappropriate activity. No one factor automatically exposes principals to liability, but as the number of infractions mounts, so do the chances that a court will determine personal liability.

Among the most critical factors:

Failing to capitalize a business or to capitalize it sufficiently.

This issue is so important that owners risk personal liability even if it is the only factor a court finds. The ultimate test is whether there are enough corporate assets to satisfy corporate obligations.

For example, despite learning that a new publishing business would require an initial capital outlay of $10,000, a San Francisco man and his partner contributed only $500 to start Bay Area Publishing Co. The business incurred costs of $650 to $1,000 a week.

Even though the partners loaned more money to the business, a California court found them personally liable for the firm's printing bills after it ran into financial trouble.

Contrast that with a Minnesota company, Fleming Sheet Metal, whose start-up capital was $5,000. The company never paid dividends. Earnings were channeled into operating capital. The firm's sole shareholder, Robert J. Fleming, lent additional capital to the business.

After the company became insolvent, the court refused to hold Fleming personally responsible for company debts because the "total equity [stated capital plus shareholder loans plus retained earnings] kept pace with corporate liabilities until the drastic losses began."

Commingling assets.

A common form of carelessness involves intermingling personal and corporate funds. Explains Fleischman: "If money is moving back and forth for loans and advances, then someone will try to pierce [the corporate veil]."

For example, Dorothy Lee owned two California corporations, Sequoia Enterprises Inc. and Fresno-Pacific Corp. She used them to conduct her lumber business in Fresno and Merced. Sequoia transferred to Fresno-Pacific Corp. accounts receivable and payable, equipment, and a building on leased land. Fresno-Pacific assumed Sequoia's liabilities; the trouble was, the debts exceeded Fresno-Pacific's cash on hand.

In addition, Fresno-Pacific moved its office equipment to Lee's residence. Sequoia owned the residence, but Lee paid no rent to live there. Meanwhile, Lee wrote a $1,200 check from Fresno-Pacific to satisfy a debt of yet another one of her companies.

A California appellate court upheld a finding that Fresno-Pacific and owner Lee were indistinguishable from each other and held Lee liable for the company's debts.

Failure to document transactions.

In 1992, two Georgia doctors and a business manager set up Total Care Inc. and two other corporations to handle their medical and chiropractic practice. Because they "transferred money back and forth between [their separate businesses] as needed, without any documentation," the principals were liable for Total Care's business debts, the Georgia Court of Appeals ruled.

Diverting corporate assets for personal use.

The president of a Los Angeles boatyard frequently bought groceries, on his way home from work. He paid with corporate checks because he never carried much cash. When a customer sued the boatyard, the fact that the president had used corporate money for his own purposes was among the reasons that a judgment was issued against him personally.

Atlanta lawyer Jack Millkey notes that many owners use company money to pay personal debts such as phone bills. "That's where you get into trouble," he says.

Absence of corporate records.

Kurt Schmalz, a lawyer in Beverly Hills, Calif., says carelessness about records such as minutes of director and shareholder meetings leads courts to treat the corporation as the "alter ego" of the owner or owners, meaning there's insufficient separation between owner and company. Hence, owners can be held liable for corporate debts.