New York law treats a corporation as an independent entity, separate and apart from its owners (or “shareholders”), and enforces a legal buffer that stands between the corporation’s liabilities and the shareholders’ personal assets known as the “corporate veil.” Sole proprietors, who share their own assets and liabilities with those of their company, commonly incorporate to enjoy the personal protection afforded to shareholders by the veil. However, merely incorporating the business does not automatically bring a corporate veil into existence; to be afforded the protection of the veil, shareholders must respect their corporation as its own independent body, entirely separate from themselves, which requires business practices and administrative procedures that many small business owners may be unfamiliar with.
New York Courts may permit a creditor to “pierce the corporate veil” and pursue shareholders directly if the shareholders are found to have used the corporation as an “alter ego” of themselves in an attempt to avoid personal liability. An “alter ego” finding is most strongly supported by business practices that show that the shareholders treated the corporation as a mere extension of their own personal affairs, such as intermingling of corporate funds with personal funds, and neglecting to follow corporate formalities. New York law also imposes liability on shareholders for certain corporate misconduct, including the failure to pay taxes or wages.
Piercing a corporate veil does not necessarily require that a shareholder act intentionally or fraudulently. Shareholders, and other business owners considering incorporation, should therefore review their business practices carefully to ensure that they are not operating the company’s affairs in a manner that risks voiding the veil’s personal protection. Some practices to take into consideration are as follows:
1. Adhere to corporate formalities. A corporation is typically operated by three groups: (i) shareholders, who own shares in the corporation, (ii) the board of directors, who manage the company’s major affairs, and (iii) officers, who carry out the corporation’s day-to-day business. Directors are elected by a vote of the shareholders, and officers are appointed by the board of directors. By default, shareholders must have an annual meeting to elect the directors, and the directors must have an annual meeting to discuss the company’s affairs, which may include the appointment of the corporation’s officers. The corporation can adopt bylaws that lay out its governance system if it wishes to deviate from the State’s default rules and procedures. All of these meetings, decisions, and documents are expected to be recorded in writing and kept in the corporation’s books.
In smaller corporations, especially those owned by a single shareholder, the same person often simultaneously acts as a shareholder, the sole director, and the officer(s). In these instances, shareholders commonly make the assumption that holding and documenting formal meetings (particularly if the meeting is attended by one person) are unnecessary. However, in the context of the corporate veil, failing to follow these seemingly inconsequential formalities can lead a court to treat the corporation and its shareholders interchangeably, permitting a piercing of the veil. A well-maintained corporate kit that contains all of the necessary records can be used to refute an accusation that the shareholders used the corporation as their “alter ego.”
2. Use the corporation strictly for corporate affairs. Unlike sole proprietors, a shareholder of a corporation is not entitled to commingle company funds with personal savings or immediately use the proceeds from a sale in the course of business to pay off personal debts or expenses. A corporation is expected to have its own bank accounts, which are used solely for commercial transactions and replenished by business revenues. Shareholders may take ownership of corporate funds only through salary payments, director-authorized dividends, or some other lawful agreement. However, even these mechanisms have their own restrictions; it is unlawful, for example, for the corporation to pay a dividend to its shareholders if doing so would cause the corporation to become insolvent. It is often best to consult with your accountant before strategizing how shareholders will earn income.
3. Remember to represent your business, not yourself. Once a business incorporates, its owners and officers must remain mindful that they conduct business exclusively on the corporation’s behalf, not on their own. When entering transactions, it is important that all pertinent written instruments are clear that the corporation is a party bound to the document’s terms. The signatory to a contract should represent herself as the corporation’s agent by using her proper title. Without the proper safeguards, a shareholder may find that she is personally bound to an agreement, or that by using her name interchangeably with her company’s, she is using the corporation as her alter ego and loses veil protection.
4. Always pay your taxes. Unsurprisingly, shareholders can be held personally liable for taxes owed by their company. When a business is struggling, it may be tempted to stay afloat using funds from collected sales taxes, or from withholdings for income or payroll taxes. However, tax authorities will undoubtedly appear to collect overdue tax liabilities with additional penalties and interest, even long after a business has permanently closed its doors and the corporation has dissolved. A corporation may wish to strategically prioritize its liabilities to ensure it has sufficient liquid assets to cover tax debts.
5. Always pay your employees. Under New York’ s Business Corporation Law, employees can recover unpaid wages from the ten largest shareholders of their employer’s corporation. In addition to the wages due, employees may be able to seek additional liquidated damages and penalties under New York Labor Law or federal law.
Many of the principals governing the corporate veil also apply to New York Limited Liability Companies, which the law also treats as separate entities from their owners (called Members). Not all practices will work best for all businesses so the contents of this article should never replace legal advice from your business attorney.