Don't Puncture the Shield

PUBLIC COMPANIES ARE NOW under the microscope by virtue of the Sarbanes-Oxley Act, and the federal court dockets show a relatively large number of former corporate officers as criminal defendants. Lost, but not forgotten, in all the hubbub are the vast majority of companies, including waste haulers, which are closely held corporations. For these private companies, the risk remains the same: Individual officers and directors can be sued in a civil action and can be held personally responsible for corporate acts and misdeeds.

The protective features of a corporation, particularly the shield afforded officers and directors from personal liability, are available only if the integrity of the corporation as a separate and distinct entity is honored and upheld. For the most part, courts generally support limited liability for corporate principals where the entity itself strictly observes business formalities and where there is no trace of fraud.

To avoid problems, closely held corporations must issue stock and be adequately capitalized; shareholders must elect directors; and corporate officers must keep careful records. Any related companies — for example, where Company A and Company B have common ownership or management — must keep separate funds and deal at arms' length with each other. Sure-fire ways to puncture the corporate shield and launch a downward spiral toward individual liabilities include using corporate funds for personal and not business purposes, paying or guaranteeing the debts of one corporation by another related entity, and sharing office space and telephone numbers with one or more companies.

An injured party — whether physically or economically harmed — that sues a closely held corporation may, depending on the circumstances, join officers and directors as additional defendants. If reasons exist to bypass the corporate entity, and the plaintiff prevails, then a judgment can be entered against the corporation as well as individual defendants. If the corporation has insufficient assets, those individuals will then be obliged to foot the bill for the judgment.

A number of financial companies offer asset protection strategies for shareholders, officers and directors to shield their corporate and personal assets from court judgments. The options include creating a family limited partnership (FLP), a limited liability corporation (LLC) or a trust to hold title to key assets such as real estate and equipment, and lease them back to the corporation at a fair price.

By creating an FLP, LLC or a trust to own important assets, a corporation can keep a creditor from reaching those assets. Moreover, LLC members can report the LLC's expenses and income on their individual tax returns, as well as deduct their health and life insurance premiums. But an LLC has its own documentary formalities that must be observed. Shares in an S corporation, a type of organization that is exempt from federal income tax other than taxes on certain capital gains and passive income, cannot be held by a FLP or an LLC. Meanwhile, some types of trusts cannot hold corporate stock.

Lots of other rules and tax traps abound. Before an executive embarks on asset protection, he should talk with several qualified advisors, including his accountant, and company and personal lawyers.