Alter Ego Blunders—Piercing the Corporate Veil

  • If your company is sued, can you be held personally liable? Many people form LLCs and corporations to protect their home and personal assets from business judgments, but the vast majority of small corporations and LLCs have absolutely NO protection, because their owner’s commit alter ego blunders.

    Alter ego means that the company appears to be an alternate version of the owner; that the law cannot distinguish a separate and distinct difference between the two. When a serious alter ego blunder is made, the law may treat ALL of the owners’ assets and activities as being personally owned and controlled by them, therefore exposed.

    The IRS often uses alter ego doctrine to collect additional taxes against S corp owners who violate the rules. By re-characterizing the favorable tax structure of the S corp to a sole proprietor or partnership, the IRS is able to assess self-employment tax and deny pretax fringe benefits to the owners and their families.

    To avoid alter ego problems:

    • Assets should be titled in the name of the entity and should only be used for the entity’s purposes;
    • There should be no commingling of entity funds with personal funds or the assets of other separate entities;
    • A federal tax ID number must be obtained for the entity;
    • A separate checking account must be set up. All income generated by the entity should be deposited into this account and all salaries, disbursements and other expenses should be paid from it.
    • The entity should be adequately capitalized and long delays should be avoided between the date of formation and the transferring of assets into the entity;
    • The entity must not pay personal expenses of its owners and should not take tax deductions for a vehicle registered in the name of the owner or other property.
    • Owners must not personally pay corporate expenses (without certain legal arrangements in place).
    • The entity must be compensated for any personal use of its assets by any of its owners;
    • Minutes should be recorded and kept of meetings and material decisions at least once a year. All personal transactions (including personal loans) should be formally approved and recorded in the minutes;
    • Distributions should be made at the same time and in proportion to the ownership interests; and
    • Income tax returns should be filed for the entity and K-1s issued to the owners.

    Caution for single member LLCs

    It’s more difficult for single member LLCs to show separation between the owner and the company. In most states and courts, a single member LLC is not protected against the creditors of the member, but there are three ways to fix that:

    • The single member should approve an operating agreement and create sufficient legal documentation to prove separation between the member and the company by following corporate law.
    • The single member could convert to a multi-member LLC by issuing a small ownership interest (e.g. 2%) to a key employee, contractor, friend or relative; or,
    • The single member LLC could formally elect to be taxed as a corporation.

    LLCs and Corporations do not protect owners from the following acts:

    • Co-signing or personally guaranteeing business debt;
    • Wrongful acts or torts, malpractice or professional negligence of an owner;
    • Failure to pay the company’s payroll taxes;
    • Failure to carry adequate insurance; or
    • Failure to comply with legal formalities of the entity.

    When the compliance rules are followed attorneys have a difficult time piercing the corporate veil and attaching the owners’ personal assets when taking legal actions against the company. California and most other states generally protect business owners who respect the States’ compliance regulations. The purposes for these laws were to encourage business ventures and risk-taking by limiting liability exposure. They were not set up to protect those who have no regard for the law.

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