Many business owners choose to organize their businesses as separate legal entities such as corporations or LLCs. There are many advantages for doing so, but one of the primary advantages a corporation or an LLC provides a business owner is limited liability protection. This means that, generally, if a plaintiff wins a lawsuit against a business organized as a separate legal entity, the plaintiff can only recover assets titled in the name of the business itself. Similarly, if an individual owns multiple businesses, and each business is a separate legal entity, then the plaintiff can only recover against the businesses named in the lawsuit. The assets of the unnamed businesses are safe.
Alternatively, if a business owner runs his or her business as a sole proprietorship (or a partnership if there are multiple partners) – that is, if the business owner chooses not to organize his or her business as a separate legal entity – and a plaintiff wins a lawsuit against the business, not only can the plaintiff go after the assets of the business, but the plaintiff can go after the personal assets of the business owner as well.
In order to receive limited liability protection, a business owner has to organize the business with the Iowa Secretary of State as a corporation, an LLC, or some other type of legal business entity provided for under Iowa law, and must follow certain corporate formalities. Simply organizing the business with the Secretary of State does not guarantee limited liability protection in all scenarios as one corporation discovered last summer in the Iowa Court of Appeals case Woodruff Construction, LLC v. Clark.
In the Woodruff case, the plaintiff was able to “pierce the corporate veil” (a legal term courts use to describe situations when limited liability protections will not apply to business owners) and recover damages against the business owner personally due to the business owner’s failure to follow corporate formalities and treat the business as a separate entity.
The court held that “[w]here the corporation is ‘a mere shell, serving no legitimate business purpose, and used primarily as an intermediary to perpetuate fraud or promote injustice[,]’ the corporate veil may be pierced.”
Factors the court looked at when determining whether the corporate veil could be pierced included the following: “(1) the corporation is undercapitalized; (2) it lacks separate books; (3) its finances are not kept separate from individual finances, or individual obligations are paid by the corporation; (4) the corporation is used to promote fraud or illegality; (5) corporate formalities are not followed; and (6) the corporation is a mere sham.”
The court found that the business owner had “egregiously” commingled funds among his personal accounts and those of his various businesses. Furthermore, the business owner had failed to follow corporate formalities such as retaining records of shareholder meetings and producing corporate bylaws, minute books, and a shareholder ledger.
Although one or two of these errors may not have been enough for the court to allow the plaintiff to pierce the corporate veil, the court ultimately determined that, in light of all of the relevant evidence, the business owner did not operate the business or its finances as a separate entity from himself and his other businesses, and consequently allowed the plaintiff to pierce the corporate veil and recover against the business owner personally.
This case serves as an important lesson to business owners tempted to ignore corporate formalities. Simply organizing a business as a corporation or an LLC does not guarantee limited liability protection in the event of a lawsuit. Although corporate formalities such as maintaining annual minutes and keeping up-to-date record books might seem like an unnecessary chore, the law requires that these rules be adhered to in order to help distinguish the entity from the business owner.