The primary reason that my clients form an entity is for asset protection. The proper entity choice prevents business creditors from getting to your personal assets.
This protection is commonly referred to as the “corporate veil.”
In some instances, a court can “pierce” this veil and the assets of the owner could be subject to liability. The rules for this vary by state, but generally this occurs when the owner does not respect the company as a separate entity. See below for some things to watch out for to preserve your corporate veil protection.
Personal Expenses
Your business needs to only pay for business expenses. Conversely, you personally should avoid paying for business expenses directly.
I often see business owners that use their business as a personal piggy bank. They pay for vacations, personal meals, personal fuel, and other personal expenses using a business credit card. The rationale of the rule against doing this is that if your business is paying for your personal expenses, it is essentially an alter ego of you as the owner, and not a separate entity.
Thin Capitalization
A company needs adequate resources to operate. If your business is perpetually low on cash to the point where you are making several transfers a week to cover expenses, it may be seen as an alter ego of the owner. Even with a new business that might not cash flow on its own, it is best to keep at least a month’s worth of expenses available in business accounts and to only transfer personal funds once a month, if possible.
Contracts
Another issue can arise when the business is not the entity named in contracts. I have seen business owners form an entity but they forget to have that entity be the party to any business contracts. Owners will sign contracts in their personal capacity instead of in their capacity as a corporate officer. Best practice would be to have the company be the party to the contract and you to sign as an officer of the entity.
Meeting Minutes
Your entity should prepare annual meeting minutes in accordance with the requirements of your operating agreement or by-laws. This shows that the corporate formalities are being respected, and that your business does not exist only on paper.
Closing
These are just a few examples of things to consider. The main thing to remember is that your business is not an extension of you, but rather a separate entity that should be treated as such.
