By: Marian L. Faupel, Esq.
The major reason for forming a limited liability company or incorporating is to avoid personal liability for the debts of the business. The problem is that debt insulation is not guaranteed if certain practices are not maintained.
First, a start-up business will probably need a line of credit and leases for business space and/or business equipment. Landlords and lessors will undoubtedly demand a "personal guarantee" from the stockholder or LLC member. If that guarantee is signed, then there is personal liability to the lender on that particular debt.
After a business has established itself and its creditworthiness, many lenders may be willing to "release" the owner from the guarantee. At that point, the company has some bargaining power and can threaten to change banks. Leases come to an end, and the business owner(s) may be able to escape a personal guarantee on the new lease.
Even if a corporate or limited liability business form is used, the owner may still have liability to lenders if certain practices are not maintained. A lender, vendor, or supplier may claim that the business was not a legitimate business entity in an attempt to reach the assets of the business owner(s). This is called "piercing the corporate veil" and most often occurs when the owner uses business resources and bank accounts for personal purposes (like personal expenses) and when there are excessive shareholder "loans" without documentation. If the business is paying personal expenses that are not ordinary and necessary under the Internal Revenue Code, the creditor can claim that the business is the alter ego of its owner. If, on the other hand, the owner includes perks and pays income tax on them, then the perks may be considered compensation and not a basis for piercing the veil.
Michigan courts have held that sloppy accounting and poor business practices, standing alone, are not enough to support corporate veil piercing. Instead, the following three factors must generally be present: (1) the entity must function like an agent of another entity or individual; (2) the corporate entity must be used to commit a fraud or a wrong; and (3) there must have been an unjust loss or injury to another person. The other person is generally a creditor who may have trusted that business income would be available for business expenses or may have relied on the assurances of the owner that a bill would be paid when the owner knew that it would not (and actually diverted income that could have paid the bill). These cases are factually intensive and are decided on a case-by-case basis if they spill into the court system.
Home-based businesses are particularly vulnerable to the argument that the business and the owner are one-and-the-same (or each other's alter ego). If the business does not have its own separate office, the owner should function in as business-like a manner as possible. A separate bank account should be set up, and deposits and withdrawals should be business-related only. It is best to establish a routine for withdrawing money from the company as compensation. Quickbooksâ or some other business software is useful for accountings. Cash in and cash out should be avoided if possible. Use of a tax identification number to buy goods at wholesale prices for personal purposes should be avoided.
In the end, the purpose of establishing a limited liability company or a corporation is to insulate the owner(s) from personal liability. That purpose is defeated if a bright line between the owner and the business is not maintained. Regular bookkeeping and accounting can help to separate personal and business activities and evidence the owner's intent to have the business stand on its own.
