A. Duie Latta, Esquire

If you are a business owner, you have probably wondered what kind of personal liability you could have because of your business. In a world where enormous liabilities can arise unexpectedly, every business owner should give serious thought to preventing business liabilities from becoming personal liabilities. Generally speaking, the solution has a lot to do with the legal structure of your business, especially whether and how your business is incorporated or organized. Specifically, the question of your personal responsibility for liabilities that threaten your business often depends on whether you are operating as a sole proprietorship or whether you have formed a separate legal entity for your business such as a Corporation, Limited Liability Company ("LLC"), or Limited Partnership.

A Sole Proprietorship Versus A Separate Entity
If your business is operated as a sole proprietorship, there is no distinction between your personal assets and your business assets. You personally own all of your business' assets such as equipment or inventory and you are personally responsible for the business' debts and obligations. Essentially, there is no legal difference between your personal affairs and the operations of your business - your business is viewed as part of your personal activities. As such, if your business causes someone injury and the injured person sues, they can sue you personally, not merely your business, because you and your business are one-and-the-same. This means that if they prevail in the lawsuit and obtain a judgment against you, they can seek to obtain your personal assets to pay the judgment. Individuals who are partners in a partnership are in the same situation - unless the individual is a limited partner in a Limited Partnership - they are personally responsible for the liabilities of the partnership.

For Pennsylvania businesses, generally speaking, if you have never filed documents with the Department of State to form a separate entity such as a Corporation, an LLC, or a Limited Partnership, you are operating your business with no distinction between your personal activities and your business' activities. As such, your personal assets are exposed to all the liabilities that arise in connection with your business. If your business is a sole proprietorship, it is essential to maintain adequate insurance since you don't have the benefit of the protection that a separate entity provides. Even with adequate insurance, many business owners find the possibility of personal liability unacceptable and try to separate their business from their personal assets. One way to do this is by forming a Corporation, an LLC, or a Limited Partnership.

In contrast to a sole proprietorship, a business that is organized as a Corporation, LLC, or Limited Partnership is a completely separate entity from the business' owners. The owners do not own the business' assets directly; instead, the business owns the assets and the owner merely owns the business. Likewise, the business is responsible for its debts and obligations and generally speaking, the business owner is not personally responsible for them (unless the owner has agreed to be). Typically, this means that the most that the business owner can lose is the value of their investment in the business and that the owner's personal assets are not at risk (although there is an exception to this that will be discussed in the section below). The protection of separating personal assets from business liabilities is only available to those businesses that are organized as a separate legal entity such as a Corporation, an LLC, or a Limited Partnership. This is one of the primary advantages of such business structures because they allow people to invest in a business without incurring personal liability or having to worry about losing more than the amount of their investment.

Keeping Your Separate Entity Separate
Although structuring your business as a distinct legal entity generally separates your business' liabilities from your personal liabilities, there are some instances where this is not the case. As discussed below, a court might disregard a business' separate legal existence and hold its owners personally responsible for its liabilities if it decides that the business is merely an alter-ego for the owners, is under-insured, or doesn't observe certain corporate formalities. This is referred to as "piercing the corporate veil," the idea being that the "wall of separation" between the business and its owners is penetrated, putting the liability of the business onto its owners. If the corporate veil is pierced or disregarded, tremendous liability can be placed on the owners. An investment in a small business could result in significant liability if its corporate form is disregarded and its owners are held personally responsible for its liabilities.

Although this risk exists, courts tend to have a strong bias against piercing the corporate veil unless there is a compelling reason for them to do so. Fortunately, many of the factors that courts use to justify piercing the corporate veil are within the business owner's control. This means that with careful planning, a business owner can make it much less likely that a court will pierce the corporate veil and hold the owner personally liable.

There are a number of reasons that might make a court decide to ignore the fact that your business is a separate entity and to hold you personally liable. Some of the conditions that persuade courts to pierce the corporate veil are:

A fraudulent intent behind the business. If the purpose or effect of having a separate legal entity is to defraud creditors, courts are more likely to disregard the separate entity and hold the business' owners personally liable. Courts will not permit business structures to be used to perpetrate fraud. Entities formed within a close time period of an allegedly fraudulent transaction are especially suspect.

Your business is significantly under-insured or "under-capitalized". If your business does not maintain sufficient insurance or possess sufficient assets to cover liabilities that ordinarily might arise in the course of your business, a court might pierce the corporate veil. You need to make sure that your business maintains the appropriate types and amounts of insurance. Similarly, you risk personal liability if you keep your business "impoverished" by contributing too few assets or withdrawing too many, leaving insufficient resources to cover liabilities that might arise.

Your business does not observe certain corporate formalities. If your business does not follow certain procedures that are expected of a legal entity that is truly separate from its owners, a court might pierce the corporate veil. Although the degree of formalities and procedures that are necessary tends to vary depending on whether your business is a Corporation, an LLC, or a Limited Partnership, courts often look for whether shareholders meetings occur, whether minutes for the meetings are created, whether the business acts by resolutions, and whether corporate books are maintained. It is important to adopt these practices and to understand and adhere to all of the formalities appropriate to your business' structure.

Your business does not maintain corporate records. If this is the case, courts are more likely to conclude that the business is only a façade or an alter-ego for the activities of its owners. This makes it more likely that a court will hold owners personal liable. It is vital to maintain adequate corporate records, particularly with regard to your observance of corporate formalities.

Your business funds and personal funds co-mingle. If you use your business' funds for personal purposes, a court is more likely to conclude that the business is not really separate from your personal affairs. Maintain separate bank accounts and financial statements for your business' funds and your personal funds. Instruct your customers to make checks out to your business, not to you personally. The more you respect the distinction between your personal assets and your business assets, the more the courts will.

The conditions described above are several of the many important factors to consider in planning how to prevent the piercing of the corporate veil, but they are not exhaustive. Courts take many factors into account when deciding whether to hold a business' owners personally liable. Furthermore, there are special tests that courts use in considering whether to pierce the corporate veil and hold a corporate owner or a parent company liable. These tests to determine whether a parent company or corporate shareholder will be held liable are more complex and require a consideration of the specific structure of the businesses and the way they are operated. Whether or not your business structure will provide you with limited personal liability depends on the specific facts and circumstances of how you operate your business. Avoiding the pitfalls described in this article can make it much more likely that your business' liabilities don't become your personal liabilities.

The attorneys at MacElree Harvey can assist you in determining whether incorporating or organizing a separate entity is desirable for your business. They can also help you to select the legal structure best-suited to your business and assist you in the observation of corporate formalities and other business governance issues.

MacElree Harvey
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West Chester, PA 19381–0660
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