Limited Liability Companies can be a valuable asset protection strategy to insulate your clients’ accumulated personal wealth. A properly established LLC exists as a separate entity from its members or owners for both legal and tax purposes. The resulting asset protection is known as the “corporate veil.” Yet many business owners fail to realize until it’s too late that the corporate veil is not impenetrable; in fact, it becomes dangerously thin when business practices are sloppy.
What does it mean to “pierce the corporate veil?”
When the IRS, a creditor or the plaintiff in a lawsuit succeeds in convincing legal authorities that your client’s personal and business assets are not truly separate, the corporate veil has been “pierced,” and the ensuing loss of asset protection can be devastating. Importantly, this loss of protection is bi-directional: those coming after your client’s business could sink their claws into his personal assets, while personal creditors could bankrupt his business to collect the money he owes them.
What is the alter ego doctrine?
In psychology, an alter ego is defined as a secondary personality that a person exhibits either by choice or due to a disorder, such as Clark Kent and Superman. In business law, alter ego is a corporation, organization or other entity set up to provide a legal shield for the person actually controlling the operation. So, the alter ego doctrine refers to cases in which the Internal Revenue Service successfully establishes that a business and its owner, or multiple businesses owned by the same individual, are one and the same. An alter ego ruling pierces the corporate veil, putting both your clients’ personal and business assets at risk.
Fortunately, there are measures that all corporation owners and LLC members can take to protect themselves from the alter ego doctrine. The underlying principles are: separation of assets, separation of objectives and adherence to corporate procedures.
Separation of assets and the dangers of commingling
The term commingling refers to any blurring of lines separating assets, whether it be lines separating personal assets from business assets or lines separating the assets of one business from the assets of another. Examples include receiving interest-free personal loans from the company, using company assets for personal purposes without reimbursing the company, using personal resources to pay company expenses without appropriate legal arrangements in place, and using one company’s assets to pay the expenses of another. If you are unsure whether a transaction would constitute commingling, take no chances. If the IRS is looking to invoke the alter ego doctrine against your client, commingling assets hands them the evidence they need on a silver platter.
To ensure both the appearance and the reality of proper separation of assets, all of your client’s businesses must be appropriately capitalized. To anyone seeking an alter ego ruling against your client, under-capitalization of a business is like a suspect’s scent on a sweatshirt to a bloodhound. The resources to run a legitimate business must come from somewhere, and the most likely explanation for a capital discrepancy is commingling.
Separation of objectives: Business decisions should clearly benefit that business
In addition to seeing to it that the assets of each of your clients’ companies remain separate from each other and from his personal assets, pay careful attention to the purposes for which company assets are used. Every expenditure, from an equipment upgrade to a business trip, should clearly serve the purposes of that specific business entity.
The principle of separation of objectives is based on the “arm’s length standard” applied in tax and legal proceedings, which stipulates that two different businesses, or a business and an individual, must have separate and different aims. Suppose your client owns one LLC that manages apartment buildings and another LLC that performs ice arena maintenance. If his apartment management company purchases a Zamboni, then it’s clearly acting in the interest of his other business.
The importance of recordkeeping and following standard business practices
Functioning companies hold meetings. They keep detailed minutes of the meetings and complete business records—not just of expenses and revenue—but also of all substantive decisions. For a corporation, following these and many other standard business practices is a legal requirement. The rules governing LLCs allow more leeway regarding how the entity conducts its business, but any LLC is free to adopt the stricter corporate procedures.
No matter the structure of your client’s company, following standard business practices either as required by law or to the greatest extent possible by choice significantly thickens and reinforces the corporate veil. Conversely, careless recordkeeping and a lack of evidence of meetings and decision-making procedures greatly increase the odds that your client will one day face an alter ego investigation.
Clark Kent might be able to fool the gullible public with a simple costume change, but IRS agents are highly skilled at spotting alter egos in disguise. The only way to securely protect your clients’ assets is to make certain that his businesses legitimately function as separate entities from himself and from each other.
This article is not tax, legal, or other professional advice and cannot be relied upon for any purpose without consultation and advice from a retained professional.
Harvey Bezozi is a CPA and CFP ®. More information can be found at YourFinancialWizard.com.