Tuesday, May 22, 2018

Really, It's Okay to Use a Corporation to Limit Personal Liability

I was browsing through some recent veil piercing cases (because that's how I roll), and I came across this gem: 

[I]t is unclear that merely using a corporation to limit personal liability rises to the level of fraud required to pierce the corporate veil.

Indagro SA v. Nilva, No. 16-3226, 2018 WL 2068660, at *3 (3d Cir. May 3, 2018). Given that limited liability is one of the primary benefits of incorporation, I think it is at least implied that using a corporation to limit personal liability is not fraud at all.  

Moreover, the corporation at issue was a New Jersey corporation, and the state law provides:

(2) Unless otherwise provided in the articles of incorporation, a shareholder of a corporation is not personally liable for the acts of the corporation, except that a shareholder may become personally liable by the reason of his own acts or conduct.

N.J. Stat. Ann. § 14A:5-30 (West). This is pretty unequivocal.  I get that fraud may be one of the acts that could give rise to personal liability, but the use of an entity to limit personal liability, when that is a core facet of the entity, is some pretty serious attempted bootstrapping.  

The case gets it right, in the end, but still, I had to point this out. To imply that it could be fraud to use a corporation for the purpose of limiting personal liability, without anything more, is simply incorrect.  

http://lawprofessors.typepad.com/business_law/2018/05/really-its-okay-to-use-a-corporation-to-limit-personal-liability.html

Corporations, Joshua P. Fershee | Permalink

Comments

There are no rules because the rules such as they are simply cancel each other out. Take Judge Fuld’s opinion for the majority in the seminal Walkowsky taxicab case.
1. Incorporation permitted for very purpose of letting proprietors escape personal liability but MANIFESTLY that privilege is not unlimited.
2. Inquiry guided by general rules of agency – if one uses a corporation to further his own rather than the corporation’s business, liable under respondeat superior.
Can anyone figure out how to reconcile these two rules? I can incorporate for the very purpose of making money and shielding myself from liability. But if I use the corporation to further my own ends, it is my agent and I am the principal, and liable under respondent superior. One rule gives the right, and one rule takes it away.
It's another instance for the "rule of pig." If you look like a pig after the fact, you end up in the slop.

Posted by: Jeff Lipshaw | May 23, 2018 8:21:43 AM

I agree that there is a circular issue here, but even Judge Fuld explained that limited liability, on its own, cannot be sufficient for veil piercing (even using "merely" in his explanation):

"The corporate form may not be disregarded merely because the assets of the corporation, together with the mandatory insurance coverage of the vehicle which struck the plaintiff, are insufficient to assure him the recovery sought. If Carlton were to be held individually liable on those facts alone, the decision would apply equally to the thousands of cabs which are owned by their individual drivers who conduct their businesses through corporations . . . ."

It seems to me, at a minimum, "merely using a corporation to limit personal liability" is still insufficient to lead to veil piercing. In addition to that, you also need to (at least) look like a pig in doing so.

Posted by: Joshua Fershee | May 23, 2018 9:44:24 AM

I agree with the premise that the use of a corporation to limit one’s personal liability is inherent to the purpose of granting limited liability. In my jurisdiction the lodestar for determination of veil piercing is “alter ego” and effecting fraud – such piercing rarely granted.

That said, my pet peeve for many years was the radio advertisements by “formation mills” that crowed, “form a corporation, protect your personal assets.” Oh, the tax consequence to unwind these formations where the gullible or uninformed failed to appreciate the effect.

Dealing primarily with small business start-ups, I would hazard to say that fifty percent of the time where the client is solely selling the service or widget, delivering and/or installing or providing the service or widget, the ultimate costs of entity formation do not deliver value. Even then, getting the client to “respect the formalities” is a herculean effort in and of itself.

Posted by: Tom N. | May 23, 2018 10:25:16 AM

Tom N — would like to hear more. Why 50% of the time was entity formation not worth it? Because if owner is the sole employee, limited liability wouldn’t protect from your own tort liability? But wouldn’t it help from the standpoint of contract liability? The formation costs outweighed the benefits? I’m curious about your experiences.

Posted by: Doug M | May 26, 2018 6:05:09 AM

Doug M: You correctly surmise the tort liability.

First, choice of how to operate is often dependent on the type of business.

Where dealing with contract and entity limitation of liability, it is a rare occasion where a small business transaction is not accompanied by a personal guarantee. In my manufacturing business (a traditional C corporation), it took 15 years of “going concern” and assets almost double that of outstanding obligations to negotiate away personal guarantees with vendors and financial institutions. So, although there exists the principal at law that there is limited liability in contract, the reality of commerce is that it is rare that a line of credit whether commercial (vendors – open terms) or with a financial institution that the proprietor or sole member’s assets are not subjected to the same level of risk as operating without a limited liability entity. So that leaves the client, if so educated, with a different dynamic of consideration.

In turn, because Tennessee does not have an individual income tax (for which Tennesseans have on multiple occasions resoundingly voiced support), business taxes serve as a major component of the State’s tax base. In Tennessee, true sole proprietors and general partnerships are not subjected to the majority of these privilege taxes. That said, the prudent sole proprietor is going to carry insurance whether they are in an entity or not. Thus, one evaluates whether the tax savings provide a far better return (or even paying a little more for coverage) where simply properly insuring for risks. Also, having well constructed contracts with customers – and clients recognizing the value of terms, conditions, risk shifting – can be more valuable than the benefit of a limited liability entity.

I have had clients, against my advice, who have chosen to operate their businesses in limited liability entities only to hear them “express regret” because of the poor value of return (taxes for the value of the limited liability) and my job was then to “get them out.”

My personal experience as an attorney holding the position as an officer within my own corporation, I had to police it constantly to make sure the safeguards of limited liability were being maximized. Making sure a small business person or entrepreneur is operating the entity in such a manner as to truly obtain the benefit was a “part-time” job. This year alone, I’ve had to go back and wholly reconstruct governing documents for several clients who - despite having capable guidance at formation (not me – often catch CPAs in-artfully practicing law) – lost or misplaced governing documents and never kept a minute book.

As you may suspect, there are many additional considerations discussion of which is not suited to this format.

Posted by: Tom N. | May 26, 2018 8:28:09 AM

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