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Piercing the Corporate Veil

Piercing the Corporate Veil
The lawsuit protection features of the corporation will be available only if the integrity of the corporation as a separate and distinct entity, apart from the individual, is respected by a court and by the Internal Revenue Service. In matters involving a lawsuit by an injured party, especially if a corporation has no significant assets, the plaintiff will attempt to convince the court that the corporate entity should not be respected and that the principals of the company should be personally liable. In these cases, the plaintiff is attempting to pierce the corporate veil in order to obtain a judgment against the principals, who may have personal assets sufficient to satisfy a judgment.

There are many reported cases on this topic, and the outcome is usually determined by whether the corporation carries out its business and looks and acts the way a corporation should. If the principals treat the corporation and hold out the corporation to third parties as a separate and distinct entity, the court will usually uphold the status of the corporation and will not find personal liability. However, if various corporate formalities are not consistently observed, the corporation will be disregarded and the individuals may be held personally liable.

One of the major problems with the corporate format for small businesses is that as a matter of course the shareholders, officers, and directors will be named in any lawsuit against the corporation. The plaintiff will attempt to pierce the corporation or will argue some theory to make the defendants responsible. In a significant number of these cases, when there is a judgment against the corporation, the court will disregard the legal protection of the corporation and will hold the defendant shareholders, officers, or directors liable.

Much of the practical protection offered by the corporate form is rendered meaningless by these cases. Sometimes the protection is upheld, and sometimes it is not. This lack of certainty makes business planning—and sleeping at night—difficult. Since the shareholder will almost always be named as a defendant in the lawsuit, even if he is ultimately successful, the attorney’s fees and the costs of defense can be financially ruinous.

There are two solutions to this problem. If you are a principal shareholder or officer/director of a corporation, use a proper asset protection plan to shield your personal assets from the potential liability associated with the corporation. Alternatively, use a Limited Liability Company (LLC)—instead of a corporation to conduct business. We will discuss the LLC in detail, but for now, you should know that an LLC cannot be pierced like a corporation and the members cannot be named in a lawsuit for failure to follow any formalities. It provides the protection against liability associated with the corporation but avoids many of the pitfalls. When considering the best asset protection strategy for your situation, determine whether the LLC is an appropriate form to conduct your business activity.

Using Multiple Corporations

If the business of the corporation can be divided into separate businesses, assets can be protected through the use of multiple corporations. For example, a single corporation may own and operate six medical clinics in different locations. If something happens at one of the clinics, giving rise to potential liability, the assets of the other successful clinics must be isolated from these claims.

A client of ours had four dental offices in different locations. All of the offices were held in one corporation. Business at one of the locations slowed down substantially. That clinic became a financial drain on the others, absorbing all of the available cash in the company. Eventually, the corporation had to file for bankruptcy, wiping out all of the equity that had been built up.

Our approach would have been to have each office separately incorporated. Then, if one location were to falter, it would not drag down the others. A judgment creditor of one corporation would not be able to reach the assets of the other companies. An extreme illustration of this is the taxicab company which separately incorporated twenty-six different taxis.

This strategy is also useful for a company that manufactures or wholesales different product lines. Companies in the pharmaceutical business face enormous potential liability for many types of drugs and medical devices. Several years ago A. H. Robbins was forced into bankruptcy by liability in connection with the IUDs it produced. Dow Corning had similar problems from the liability associated with the silicone breast implants. Whenever a particular product may be hazardous, using multiple corporations is an effective technique for insulating each separate product from liability caused by another.

Protecting Personal Assets
Is a corporation a good strategy for shielding personal assets from potential lawsuits? This is a question which has produced needless confusion and misleading advice. There are many heavily promoted schemes—generally involving Nevada corporations—which claim to provide a myriad of asset protection benefits.

Our view is that the corporation is generally a poor choice as a vehicle to protect assets. It is clumsy, inefficient, and usually better methods will be available.

The source of the problem is that a judgment creditor can seize any shares of stock which you own. If you transfer assets to a corporation in exchange for stock, the creditor simply takes the stock certificates and becomes the owner of those shares. If he obtains more than 50 percent of the shares, the creditor is then in control of the company—and your assets. We will see that this result differs from the Family Limited Partnership or LLC arrangement where the creditor cannot get the right to vote or manage the entity and, therefore, cannot reach the assets held by the company. Since the shares of stock of a corporation are reachable by judgment creditors, a corporation will not provide a significant degree of asset protection, in the event of a successful lawsuit against you.

Some degree of asset protection can be accomplished if you move the shares into a protected position. For example, corporate shares can sometimes be transferred to an entity that provides necessary legal protection for assets such as a Family Limited Partnership (FLP), LLC, or a trust. But there are lots of rules and tax traps for the unwary. For instance, shares in an S Corporation cannot be held by an FLP or LLC. Also, only certain types of trusts are permitted shareholders. Hazardous and unintended tax consequences occur frequently with corporations, and so all transactions should be carefully planned and monitored.

Achieving Financial Privacy
Conducting business in a corporation can sometimes create financial privacy advantages. The corporation is a separate entity for legal purposes. It is required to obtain a Federal Tax Identification number, which is separate from the Social Security number of the owner. Real estate, bank accounts, and other business interests can be legally owned in the name of a corporation. The identity of the shareholders of a corporation is not required in any public filing with the state regarding the incorporation or maintenance of the company. In theory, at least, the names of the shareholders are private and evidence of your ownership is not available for public access. But there are many holes in this general principle. Companies with publicly traded shares are required to disclose the names of principal shareholders in regular reports to the Securities and Exchange Commission and various state regulatory agencies.

The identity of the shareholders of privately held companies must be maintained in a written record in the stock ledger book of the company which is as secure as the procedures implemented by the custodian of the corporate records. In addition, information about the stockholders of a private company may be developed by the database services through voluntary disclosure on credit and insurance applications, business and professional licenses, and other regulatory filings. Corporations must annually file, with the state, the names and addresses of corporate officers and directors. If you are listed as an officer or director, a database search will reveal this connection to your corporation. It doesn’t matter which state you have chosen to incorporate in—Nevada, California, Delaware—every state has the same requirement and the information is publicly available.

Example
Let’s say that, in order to maximize your privacy, you have a friend or business associate serve as the sole officer and director of the corporation. Alternatively, there are companies and individuals who offer these services, for a fee, to newly formed or existing corporations, mostly in Nevada. They promise to follow directions and act as your agent with regard to the corporation. For convenience, we will call your “friend” Gumby. Gumby’s name—but not yours—will now be recorded publicly. If he carefully executes all corporate filings and documents, your name will probably not show up in a search of the databases.

The more difficult privacy issue involves the matter of signature authority with regard to corporate assets. Who should be authorized to sign on the corporate bank account? Although the account itself is in the name of the corporation—with its own Federal Tax Identification number the law requires that the bank obtain the name and Social Security number of every account signatory. If you are a signatory on the account you must supply this information. Your name and Social Security number on the account then provides the link to you—exactly what you were trying to avoid in the first place.

You can eliminate this difficulty by having Gumby as the account signatory—but you have now created serious dangers for yourself. You have made Gumby the sole officer, director, and signatory for all corporate assets—presumably valuable to you or you wouldn’t be going to this much trouble. In essence, you have turned over to Gumby much of what you own. As attorneys, we see so many risks and opportunities for fraud with this type of arrangement that we don’t recommend it for our clients.

One of the largest companies supplying these services was recently raided as part of an IRS crackdown. Computers and files were seized, and criminal investigations are proceeding. Imagine the inconvenience of getting Gumby’s signature on a check when he is operating from the federal penitentiary. If your goal is financial privacy, we will show you that there are safer and more efficient alternatives which will accomplish the desired result.

Summary
We have seen that the corporation can provide benefits by limiting the liability of business owners from particular sources of lawsuits. This general rule will not apply to physicians, dentists, attorneys, engineers, CPAs, and other licensed professionals. These individuals remain personally liable for acts of malpractice.

In other cases, a corporation will be especially effective in situations involving negligence claims and disputes with customers. However, lawsuit protection will be lost if the corporate entity is disregarded by the courts, a very real risk for most smaller companies. In attempting to preserve the sanctity of the corporation as a separate and distinct entity, proper minutes and accounting records must be maintained. Correspondence and contracts with third parties also must clearly establish that it is the corporation, and not the individual, which is conducting the business.

Because of the risk of being named as a defendant in a lawsuit against the corporation, the principal owners, officers, and directors should carefully protect their personal assets from this potential liability. Corporate assets can and should be protected through multiple entities and a variety of asset protection strategies to make the company an unattractive lawsuit target. If permissible, corporate shares must then be held by an entity such as the Family Limited Partnership, Limited Liability Company, or a trust in order to prevent a creditor from seizing the stock.

The corporate format poses a variety of issues regarding financial privacy. Although there are no public records of the shareholders of privately held companies, considerable information is available from insurance and credit applications and government regulatory compliance. Signature authority over corporate assets will also provide an easily discernible trail leading to your door. Gumby’s services can be used to act as agent for signing on accounts and corporate documents, but they are notoriously unreliable and present significant dangers from fraud or other malfeasance. In the succeeding chapters, we will see how asset protection techniques can be used to solve many of these problems and to accomplish your important objectives.

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