When lawyers speak of “piercing the corporate veil” we are referring to the court’s ability to disregard a corporate entity and hold the individual stockholders or members personally liable for debts incurred by the business. This is why there is so much “to do” being made about keeping up corporate formalities. What is lost in most of these conversations is the real reason why it is so important. In reality, courts in Kansas are very reluctant to pierce the corporate veil. Absent a showing of fraud or deceit, spotty corporate records are seldom enough for a court to disregard an entity. Then why all the fuss? Because litigation is terribly expensive. The point is not to survive a “piercing the veil” argument; the point is to stop it before it ever gets started. Unfortunately, these lawsuits typically only arise when a business has failed, otherwise there would be no need to come after you personally. This makes the financial burden of defending a lawsuit even more cumbersome because you no longer have that business as a source of income. Analyzing the factors that courts use to decide these types of lawsuits will go a long way in helping you developing good corporate practices which in turn should dissuade the initiation of such actions. In the event that you are sued, avoiding the factors described below, should help you get out of litigation quickly and back to doing what great entrepreneurs do best… starting over.
Factors Justifying a Disregard of the Corporate Entity:
In Kansas, there are eight (8) factors which are significant in justifying a disregard of a corporate entity: (1) undercapitalization of the entity, (2) failure to observe corporate formalities, (3) nonpayment of dividends, (4) siphoning of corporate funds by the dominant stockholder, (5) nonfunctioning of other officers or directors; (6) absence of corporate records; (7) the use of the corporation as a façade for operations of the dominant stockholder, and (8) the use of the corporate entity in promoting injustice or fraud. See Amoco Chemicals Corporation v. Bach, 222 Kan. 589, 594 (1977). In Emprise Bank v. Rumisek, 215 P.3d 621 (Kan. App. 2009), the Kansas Court of Appeals specifically applied the eight factors above to the use of a limited liability company.
Members of an LLC have a good faith duty to put at the risk of the business unencumbered capital reasonably adequate to cover any future liabilities. See, Service Iron Foundry, Inc. v. M.A. Bell Co., 2 Kan. App. 2d 662, 676 (Kan. App. 1978). What is considered reasonably adequate capitalization really depends on the nature of the industry the business operates in and the risk that it entails. Before forming an LLC you will want to forecast what your start-up and operating costs are going to be. The best way to do this is talk to a business owner already operating in the industry. SCORE (Counselor’s to America’s Small Business) also recommends you add 20% to your projected operating costs to account for any unexpected costs that may come along. In addition, Kansas courts will analyze whether there is adequate insurance in place to cover potential risk of loss. You will want to make sure you put insurance in place prior to forming your LLC and adjust your coverage if the company’s exposure to risk increases. This duty also extends throughout the life of the company. So if the company takes on further liabilities without sufficient assets to cover such liabilities it will mostly like be viewed negatively by the courts under this factor.
Failure to Observe Corporate Formalities
With corporations, Kansas courts will strictly scrutinize every activity the company ever engaged in to ensure that it conforms with corporate formalities. In Scutte v. Peter, an unpublished Kansas Court of Appeals case, the Court took interest in a corporation’s activities noting that “many, but not all, of the corporate formalities were observed”. In this case, despite that the corporation held annual meetings, keep minutes of those meetings, maintained separate banking accounts, filed annual reports with the secretary of state, and filed corporate tax returns, the Court still took issue with loans the corporation entered into because the loans were not authorized by the procedure stated in the corporation by-laws.
Generally, limited liability companies do not require the same rigid formalities that corporations do. The Kansas Revised Limited Liability Act (“Kansas LLC Act”) is permissive and gives the member’s of an LLC a wide range of latitude in holding meetings, designating quorums, and voting procedures. Therefore, in a limited liability company analysis this factor should probably be given less weight than as if analyzing a corporation. Even so, courts will no doubt look to see if members properly followed procedures as dictated in the company’s operating agreement or in the Kansas LLC Act. In addition, observing corporate formalities will aid members in avoiding the other factors under this analysis, such as, failure to keep corporate records and siphoning of corporate funds. This is why having an operating agreement in place and following it is so important. If an action requires a meeting and vote of the members make sure you do it and record minutes of that meeting in the LLC record book. If the operating agreement requires quarterly distributions of excess cash to the members, then make those distributions. Make sure you strictly keep LLC funds in a separate company banking account and use it only to pay for LLC expenses, file all your tax returns on time, and make sure you file your LLC annual reports. Even if the operating agreement doesn’t require it, members should hold and document an annual meeting to discuss the prior year’s events, to review the operating agreement, and to authorize an upcoming actions to be taken on behalf of the LLC. Many of these actions will also carry over in analysis of the other factors.
Nonpayment of Dividends
Unless the members of a limited liability company choose to be taxed as a corporation this factor will usually be disregarded by courts when deciding whether or not to set aside the limited liability status of an LLC. Even if a LLC is taxed as a corporation the non-payment of dividends should not be a problem so long as excess funds are reinvested in back into the LLC.
Siphoning of Corporate Funds
Anytime members use LLC funds to pay for their personal expenses they are siphoning corporate funds for purposes of this factor. See Kvassay v. Murray, 15 Kan. App. 2d 426 (Kan. App. 1991). Members who make frequent withdrawals to themselves out of LLC funds, not in accordance with the LLC operating agreement, will also find themselves in trouble under this factor. As mentioned in earlier posts, the amount and timing of distributions to members is largely a management issue, however, a LLC is prohibited from making a distribution to a member when the liabilities of the LLC exceed the fair market value of the assets of the LLC. See K.S.A. 17-76, 110(a). For purposes of this calculation liabilities of the LLC do not included nonrecourse liabilities. Additionally, if members take distributions rendering the LLC unable to cover its liabilities courts may also make a finding that the LLC was undercapitalized.
Nonfunctioning of Other Officers or Directors
Unlike corporations LLCs are not managed by directors; they are managed either directly by the members themselves or by a manager designated by the members. K.S.A. 17-7693(a). Technically, the members and managers may designate the responsibility of managing the LLC to officers or any other agent, but this factor usually won’t be applicable to LLCs in a piercing the veil analysis.
Absence of Corporate Records
Failure to file annual reports, file tax returns, keep financial statements, and to document the transactions of the LLC can all weight negatively against members of an LLC under this factor. Keeping good corporate records helps to establish the separate legal identity of your LLC. The more detailed documentation you keep the easier it is to convince a judge to grant your summary judgment motion.
The Use of the Company as a Façade
This factor comes into to play when a corporate entity is used as a front for the owners to carry on their own personal business through the entity. Kansas courts are typically more likely to find the presence of this factor when there is evidence of undercapitalization, lack of corporate formalities, and siphoning of corporate assets. Common examples could include making large withdrawals of cash or other property rendering the LLC insolvent, not properly documenting transfers of assets, and failing to follow procedures in the LLC operating agreement.
The Use of the Corporate Entity in Promoting Injustice or Fraud
This is by far the most important factor analyzed by Kansas courts as it can be the sole justification for disregarding corporate entity. “Injustice alone will support a disregard of the corporate entity.” Kvassay v. Murray, 15 Kan. App. 2d 426, 440 (Kan. App. 1991). Here, the court tends to weigh all the other factors to determine whether some sort of impropriety occurred. Taking on an obligation with no intention of paying it back, engaging in fraudulent transfers, depositing cash into the entity and removing it when equally convenient all weigh negatively under this factor. With that being said, it is important to note that a creditor’s mere inability to collect a judgment is not enough to show fraud or injustice resulting from use of the corporate entity. See Luckett v. Bethlehem Steel Corp., 618 F.2d 1373, 1379 (10th Cir. 1980). This would after all defeat the entire purpose of forming an entity with limited liability protection. Where owners find themselves in trouble is when they engage in transactions that have no other business purpose solely than to hinder the collection efforts of a creditor. In a lawsuit creditors will do their best efforts to make even the most honest transactions appear as self-dealing or illusory. This is why you must document every transaction engaged in by the company especially transactions involving the LLC members or other entities owned by the members and articulate the transaction’s specific business purpose. Proper planning and adequate record keeping can go a long way in dispelling these types of allegations.
Keeping good company records and acting in an ethical strait forward manner is not only good from a legal prospective but it is also just good business practice. Sometimes litigation over an unpaid corporate debt is going to unavoidable. Engaging in proper business practices along with proper business and asset protection planning should aid you in getting these cases properly dismissed or in settlement before having to expend large amounts of money on defending a full blown lawsuit.
John Thompson is a shareholder with Kennedy Berkley Yarnevich & Williamson, Chartered assisting entrepreneurs, families and farmers in the areas of estate and business planning.