Liability Protection

The modern business corporation is its own legal entity that has legal characteristics, including being able to transfer ownership without changing its own legal status and being able to continue its existence even if shareholders should die or transfer their ownership by selling their shares of stock. Additional benefits of forming a corporation is that the shareholders have limited liability. This means the shareholder is not personally responsible for the corporation’s debt, is insulated from judgments against the corporation, and is not personally affected from the criminal actions of the corporation. In some jurisdictions, there is limited liability for the corporate officers and directors from criminal acts of the corporation.

What is liability protection?

Liability protection for a shareholder of a corporation was invented in the 17th century. In our society, our laws for legal liability mean that it is a situation which a person is liable because of a wrongful (civil and criminal) act against another person. In general this wrong is an act that our society says would be grounds for a lawsuit. A lawsuit could force the person or corporation who committed this act to rectify the wrong, which generally means paying money to the person or entity who was wronged. This wrong can be the harm of another’s body, property, legal rights or a duty if a written law was breached. One reason corporate liability protection was started was because investors were reluctant to invest in a business venture. Often this investment meant that risk of personally guaranteeing the entire debt by financing the project put their personal assets at risk.

In business, a corporation is considered to be a person or a separate legal entity. A corporation is guided by a set of statutory laws and its own internal laws (articles of incorporation, bylaws, policies and procedures) which directs its behavior. This area of law is called business law. In business law, given that the corporation was appropriately formed, the corporation can provide limited liability protection for owners, management, and staff who are working within the confines of statutory law and the corporation’s articles of incorporation and bylaws. Without this protection, owners, management, and staff could be personally liable, exposing all of their personal assets, for the actions of the corporation as a legal entity. For this reason, many business owners choose to incorporate which means they have a different role within the corporation than they would have if they ran their business as a sole proprietorship. If something happens to a sole proprietorship and it goes bankrupt, all of the unrelated personal assets, such as the personal residence of the sole proprietor are at risk. In a corporation, a shareholder (owner) will only loose the amount they invested in the form of the value of the stock decreasing.

What is corporate liability protection’s relationship to managing risk? Corporate liability protection should be part of an overall strategic plan by the board of the corporation, directing its officers and staff to identify and manage the risk to the corporation.

Why is liability protection important?

Liability protection limits the personal risk of financial ruin for the shareholder(s) if the corporation should go bankrupt or from other unfortunate judgments. A business owner who runs a business as a sole proprietorship or partnership has everything at risk.

What are the benefits from liability protection?

By protecting shareholders from personal liability, a corporation as a legal entity, has the flexibility to own assets which it can borrow to secure financing and enter into contracts. In general, the shareholders are not responsible for the debts and taxes of the corporation. If the corporation should get sued, the creditors can only go after the corporation’s assets, not the shareholders personal assets. Another benefit in a publicly held corporation is that by limiting shareholder liability it serves a purpose in allowing huge sums of capital to be raised with less risk to the individual investors.

Is corporate liability protection also called the corporate veil?

Yes, liability protection is commonly called the corporate veil. Piercing of this corporate veil is part of business law that describes a legal decision where the shareholders of a corporation are held personally liable for the debts and liabilities of the corporation despite the general principal that the shareholders are immune from lawsuits where the corporation is the only legal entity held liable. This concept only occurs with privately held business entities. It is difficult to pierce the corporate veil for publicly held companies because of its large number of shareholders.

Process, Issues of Securing and Maintaining Liability Protection

Who is protected by the corporate veil?

The shareholders of the corporation are protected by the corporate veil.

What does the corporate veil protect from?

The corporate veil protects the shareholder from the corporation’s actions where its actions could be judged liable.

What are some of the considerations for a business owner to consider when incorporating?

In many states, one of the risks a member of the board of director has is the issue of paying taxes and the risk that taxes may not be paid in a timely manner potentially. A non-incorporated business owner may be personally liable if taxes are not paid. A business owner may give serious consideration to incorporating when the business is generating enough profits that the tax payable on such profits equals or exceeds the minimum tax payables in the state in which the business in being conducted.

How is the corporate veil initiated?

The corporate veil is initiated when the corporation is formed and its articles of incorporation have a statement that provides liability protection to its shareholders.

How is the corporate veil maintained?

In privately held corporations, often the principal shareholders also are members of the Board of Directors and may be officers of the corporation. The corporate veil of liability protection is maintained with the articles of incorporation that commonly include an indemnification agreement creating an exemption from incurred liabilities for the directors and officers from their actions. Each state has its own requirements, but generally state laws determine what kind of action a board member must take to void this indemnification. As a general rule, if Board of Directors and officers act in good faith, within the scope of their duties, and avoid wrongful acts, they will be protected by this indemnification clause. Board of directors and officers can guard from personal liability by getting the corporation to pay for their legal defense and to reimburse for any damages. This indemnification clause generally authorizes the corporation to purchase insurance, called director and officer (D&O) insurance to meet the requirements of the indemnification clause.

How is the corporate veil lost?

Protection from personal liability can be lost of the shareholder gives a personal guarantee, if the incorporation process was defective, if a shareholder, director, or officer signs a contract or personally accepts revenues without explicitly stating that the individual is signing on behalf of the corporation, or if a shareholder, member of the board of directors, or officer, conducts himself in a manner that state law could determine to be a wrongful act.

What causes the corporate veil to be pierced?

Courts will pierce the corporate veil, putting the corporation’s liability protection at risk, under a number of circumstances. Each state has different requirements, but generally the corporate veil can be pierced if the corporate formalities are not followed such as not having an annual meeting, not keeping minutes, not maintaining proper filings with the state, not maintaining its own property, financial books and accounts; if it was under capitalized; or if it can be proved that the establishment of the corporation was a sham whose intent was to defraud. This means that the owners, directors and officers can not co-mingle their personal assets with the assets of the corporation; if principals engage in criminal activities and if a court decides to pierce the corporate veil because state or federal laws were broken.

Other factors courts will look at include the issue of individual control and the amount of financial interest, ownership and control the principals maintained over the corporation and if the principals used the corporation to advance their personal interests. If the interests between the corporation and the principals are so united that the interests can not be separated, courts may decide to pierce the corporate veil allowing the principals to stand personally in the stead of the corporation. In addition, if it is determined that the formation of the corporation was a “sham”, established to facilitate a fraud against third parties, courts may pierce the veil, setting aside the corporation, and allow the victims to recover from the personal assets of the principals.

If the corporate veil is pierced, what are the potential issues?

Depending on the circumstances of how the corporate veil was pierced, at a minimum, the issues for the shareholder is that the shareholder could be personally liable for their actions, putting their entire personal assets at risk.

In summary, for most business owners, incorporating a business to protect their personally liability is a powerful tool. The incorporation process has many other benefits for the principals. A certain amount of legal astuteness is important for the principals to understand these benefits and conduct themselves as principals within the corporation that takes advantage of the benefits of incorporation including corporate liability protection.