Many people assume that a corporation or an LLC insulates its principals from liability.  That is not necessarily true.   The principal is protected from contract liability.  He is also shielded from tort liability unless the principal him/herself commits the tort.  For example, if X, the president, director and an owner of stock in a corporation is negligent in an accident, in the course of the corporation’s business, the corporation and X are liable.  If, however, the corporation has an employee who is negligent in such an accident, only the corporation is liable (as long as X was not at fault).

As mentioned above, the law protects the principal from contract liability.  Principals may, however, voluntarily undertake contractual liability.  Banks may require personal guarantees of the principal in connection with loans to the corporation and landlords may require personal guarantees in connection with leases to the corporation.  There are many other instances.  For example, I recommend to my clients that are food wholesalers, when extending terms, to include a personal guaranty of the principal on the corporate credit application.

Courts will also impose liability in certain cases by “piercing the corporate veil.”  This is an equitable doctrine and thus very flexible; courts will use it to make liable principals of corporations in order to prevent fraud or to do justice in particular situations.  The cases in Massachusetts are a little confusing but Massachusetts courts have recently adopted a 12 part test, asking:

  1. In the case of multiple corporations, whether there was common ownership,
  2. Whether there is “pervasive control,”
  3. Whether there is a confused intermingling of assets,
  4. Whether there is thin capitalization (Have the owners enough equity in the business?),
  5. Whether there is a non-observance of corporate formalities (Do directors approve important matters?),
  6. Whether there is an absence of corporate records (Is there a minute book?  Bylaws?  Minutes?),
  7. Whether there is a record of non-payment of dividends,
  8. Whether the corporation was solvent at the time of the transaction that is the subject of the lawsuit,
  9. Whether there was “siphoning” away of corporate funds by the dominant shareholder,
  10. Whether there was non-functioning of corporate officers and directors,
  11. Whether the dominant shareholder used the corporation for personal matters (Are personal bills paid out of the company’s checkbook or are company assets used for personal use?  I was once involved in a lawsuit that involved a corporation paying utility bills for service at the homes of the controlling shareholders),
  12. Whether the corporation was used in promoting fraud.

At least one Massachusetts case has embellished the 12 tests above and adopted further tests. A glance at the twelve factors shows that a lot of the factors are subjective, but the corporation can and should take steps to make sure that the objective factors are met.

The above is applicable to an LLC.  Is it worth it to incorporate or to form an LLC?  The answer is that it depends on the particular circumstances.  Incorporation or formation of an LLC itself is not expensive but it does result in annual fees, taxes and other expenses.  This must be weighed against the benefits of a somewhat limited liability.  This is one more thing that should not be done at home, but at your attorney’s office.

Posted August 4, 2011 by Edmund Polubinski, Jr.