When working with both individuals and businesses (both new and ongoing), I often get asked whether the corporation that is or was created will protect them from liability (in the general sense). I try to give my best response to such an open-ended question, which is usually something like, “[w]hen done right, a corporate entity may insulate you from exposure to liability, but it takes some work and effort.” People will often translate this into, “Yes, it does.” A bankruptcy case out of the District Court for the Northern District of Illinois highlights the concept of limited liability gone awry. It also reveals, however, what the parties could have done RIGHT to have the concept of limited liability work for them, and steps you can take to ensure it works for you and your business.
The debtor in the bankruptcy case, Husband, was married to Wife. At the time of the filing of the bankruptcy by the Husband, the three corporations were owned by Laura. Husband functioned as an officer and operator of the businesses, as Wife had been sick for some time and unable to work. Husband, by the time of the bankruptcy filing, had been operating the day-to-day affairs of the businesses, as well as managing the finances of the businesses, although Wife remained owner of them and received no income from the businesses.
Under the Husband’s operation, the three businesses, at one point or another, shared a single checking account. That one bank account was used to pay expenses of all three businesses, as well as personal expenses of both Husband and Wife. Although neither Husband nor Wife worked for one of the companies, they would receive checks from that company. Also, prior to filing for bankruptcy, Husband did not have any bank accounts or credit cards of his own.
Even after filing for bankruptcy, the Husband-Debtor did not follow court rules, and open and operate solely out of Debtor-in-Possession (“DIP”) accounts. Rather, he opened a DIP account, as well as an account under one of the businesses, didn’t close the old bank account, and continued to operate from the old, shared bank account. When Husband’s case was converted from a chapter 11 to a chapter 7 case, he moved all the funds in his DIP account into one of the business accounts.
Subsequently, a few creditors of husband sued to bring these corporate entities and their assets into Husband’s bankruptcy. They argued that the Husband-Debtor operated as the alter ego of these businesses, and so no corporate limited liability should attach. The Husband-Debtor had several defenses, but most relevant here is that the facts do not support piercing the corporate veil.
In this court’s analysis, it identified the standard a plaintiff must bring to pierce the corporate veil so that there is no protection of limited liability. A plaintiff must show two things: “such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist; and second, circumstances must be such that an adherence to the fiction of separate corporate existence would sanction a fraud or promote injustice.” The court went on to further identify factors considered when determining if there is sufficient unity of interest and ownership, including: “commingling of funds, assets, or identities . . . failure to operate at arm’s length; failure to comply with corporate formalities, as well as nonfunctioning of other officers and directors, and the corporation being a façade for the operation of the dominant shareholders.”
In the case at bar, the facts clearly demonstrated that there was a unity of interest and ownership, such that the Husband and the Companies were not separate. As noted throughout the case, the Husband-Debtor used mixed bank accounts to pay expenses of all the businesses as well as personal expenses. The opinion noted that corporate formalities were not conducted (one of the companies even failed to file tax returns for five years). Also, as pointed out, the Husband and Wife were the people behind the businesses, but since the Wife was ill, all of the activities of the businesses were governed by the Husband. Ultimately, the court ruled that the businesses can be treated as assets of the Debtor, and administered in his bankruptcy case. In re Tolomeo, 15-C-8118-SLE (N. D. Ill., Dec. 15, 2015).
Corporate entities work great when the people behind the business use them properly. Many businesses are owned and operated by one person. That doesn’t mean that you can disregard the expectations of corporate management. You should maintain separate deposit accounts: business accounts pay for the business’ expenses and not your personal expenses. Calendar shareholder and officer meetings, and document them (it might sound silly for one person, but it takes five minutes). Understand liability when you take on a loan – whether the corporation is the liable entity or whether the individual is a guarantor. Observing a few formalities, including good bookkeeping, will go a long way in ensuring you, as an owner of a corporation, are protected by limited liability.
Have you wondered whether you are exposed to the liabilities of your company (or vice versa)? Feel free to share your thoughts.