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Business Entity Formation

There are many advantages and protections available when you register your business as a corporation, LLC or other entity. However, if your business does not follow the required “corporate formalities,” a court may decide to “pierce the corporate veil” in order to make your own personal assets available for injured parties.

There are several types of business entities to choose from and you should make sure you understand the benefits and pitfalls of each before you make a decision. The most common types of business entities are corporations and limited liability companies (LLC). These business entities limit personal liability in the event of a lawsuit. For example, Jim owns XYZ Stables, LLC. Someone is injured on XYZ’s property and sues XYZ for damages. Generally speaking, Jim will not be personally liable for any damages, rather XYZ will be responsible. Jim is ensured that his house, personal accounts and other personal assets will not be in danger of being sold to satisfy a judgment. The same limited liability is available with a corporation as well. However, LLC’s and corporations are taxed differently and it is important that you understand the tax implications of each before you settle on one or the other.

Once you decide which entity is best for you and your business, you will need to register your business with the State (easily done on the Indiana Secretary of State’s website), and pay the appropriate fees. The mistake many people make is that they stop after this step. However, once you are registered with the State, you are not necessarily in the clear. If you establish a business entity, you must follow certain formalities to maintain the limited liability protections provided by the entity. That is to say, if you form a business entity with the specific intention of avoiding personal liability, but don’t actually run the entity like a business, a court can “pierce the corporate veil” and make your personal assets available to settle the claims of injured parties. There are eight factors a court will look at in determining whether to pierce the corporate veil:

  1. Undercapitalization;
  2. Absence of corporate records;
  3. Fraudulent representation by corporate shareholders or directors;
  4. Use of the corporation to promote fraud, injustice or illegal activities;
  5. Payment by the corporation of individual obligations;
  6. Commingling of business and personal assets and affairs;
  7. Failure to observe required corporate formalities; and
  8. Other shareholder acts or conduct ignoring, controlling or manipulating the corporate form.

While not one of the eight factors is controlling, the courts will examine each factor in a balancing test to determine to pierce the corporate veil because “the corporate form was so ignored, controlled or manipulated that it was merely the instrumentality of another and that the misuses of the corporate form would constitute a fraud or promote injustice.”

Let’s take a look back at XYZ Stables, LLC to see how this works. Jim registers XYZ with the State as an LLC, but doesn’t maintain any corporate records, XYZ doesn’t have a bank account, any money Jim earns through XYZ is deposited into his personal account, and Jim purchases supplies and pays XYZ debts from his personal account. Under these circumstances, if XYZ is sued, a court is likely to pierce the corporate veil because XYZ only exists to offer Jim protection from personal liability. However, if Jim maintained the appropriate corporate records, set up a bank account for XYZ into which XYZ’s earning are deposited and from which XYZ’s debts are paid and supplies are purchased from, a court is much more likely to refuse to pierce the corporate veil.

Additionally, LLCs and corporations need to formally maintain their existence in order to ensure the availability of the limited liability protection provided by such business entities. This requires filing a biannual business entity report with the Indiana Secretary of State. Failure to make this simple filing will result in the administrative dissolution of the business entity and necessitate a burdensome reinstatement process.

In order to better protect your own personal assets, there are several things you can do:

  • Determine which type of business entity is appropriate for you and your business.
  • Register and file the appropriate paperwork with the State of Indiana.
  • Understand what paperwork and information you need to maintain for your business.
  • Set up and maintain a bank account from your business.
  • Deposit all earnings from your business directly into the business account.
  • Make all purchases for the business from the business account and pay any business debts from the business account.
  • Do not use the business account to pay your personal debts or make any personal purchases.
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