Photo courtesy of Wealth Bridge Corporate Services
By Ralph Preite and Allison Massey
When one intends to form and operate through one or more business entities, it is important to familiarize oneself with different corporate structures and the ways business owners can minimize their personal liability and risk. The basic way is to form a corporation to hold and operate the business. As the business grows, the business owner can further isolate liability by forming a holding company to hold and oversee the major activities of its subsidiary companies. In most cases, this structure allows the owner of the holding company to avoid incurring personal liability through the actions of its subsidiaries, whether they are commercial or tortious.
For liability purposes it is important to ensure that the relationship between the holding and the subsidiary company be structured correctly. To qualify as a subsidiary, a company must be wholly or partly owned by the holding company. The holding company must also determine the composition of the subsidiaries board of directors, own at least 50% of the total number of votes in a general meeting, or own at least 50% of the issued share capital of the subsidiary company.
While exercising this considerable amount of control over a subsidiary, it is important that the holding company also stay out of its day-to-day management of the subsidiary. The independence of a subsidiary and its management from the holding company is critical for maintaining the separation between the liability of the holding company and that of its subsidiary companies. A good way to ensure that the two companies are kept separate from a control liability perspective is to establish different bylaws and regulations in their respective Articles of Incorporation. This helps ensure that while the holding company can still generally oversee the activities of its subsidiary, the subsidiary company operates independently on a day-to-day basis.
In most cases, maintaining this structure between a holding company and its subsidiaries shields the business owner of the holding company from liability incurred by its subsidiary companies. But in some instances, a court may allow creditors or claimants to “pierce the corporate veil” and disregard the corporate structure and impose personal liability on a business owner.
When may a court “pierce the corporate veil?” The New York case Van Dorn Holdings, LLC v. 152 W 58th Owners Corp. identified two separate requirements for disregarding the corporate form and imposing personal liability on the business owner: First, the owner must be conducting business through the subsidiary for their own personal use and purposes. Van Dorn Holdings, LLC v 152 W. 58th Owners Corp., N.Y. Misc. LEXIS 3077 (2016). A court may determine a subsidiary was used for a business owner’s own purposes if corporate records and formalities weren’t maintained or if the funds and assets of both the holding company and the subsidiary company were co-mingled. This underscores why maintaining and observing the different bylaws and regulations of the companies is so crucial. A business owner who conducts business through a subsidiary according to the provisions laid out in the Articles of Incorporation is more likely to be protected from incurring personal liability. Courts have also been known to impose personal liability if a subsidiary is “undercapitalized,” which occurs when a subsidiary company does not have sufficient assets to cover its liability.
The second requirement from Van Dorn is that either a fraud (i.e., some kind of intentional wrongdoing) is perpetrated by continuing to observe the corporate form or the promotion of injustice. Though what exactly constitutes a “promotion of injustice” is not spelled out in the case, the court held that creditors losing out on money they were owed did not rise to a “promotion of injustice” or fraud.
When a business owner operates through several companies, it is wise to avoid personal liability for the actions of these entities by establishing a subsidiary company wholly or partly owned by a holding company. To do so, a business owner should ensure that their subsidiary acts as an entity independent from the holding company by establishing different corporate forms and procedures through bylaws and regulations through its Articles of Incorporation. An owner should avoid any fraudulent acts, as well as acting through a subsidiary or co-mingling the assets of a subsidiary and its holding company outside of the established corporate procedures. An owner must also ensure that a subsidiary has sufficient assets to cover any liability it may incur to avoid incurring liability through the “undercapitalization” of the subsidiary.
For additional information about how to avoid personal liability through the corporate structure, please contact the knowledgeable attorneys at KI Legal for specialized assistance.
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