Many business owners believe they are separate from their company and cannot be held liable for the company’s actions. However, a court may attempt to pierce the corporate veil and hold an individual — a shareholder or director — liable for a company’s actions or debts by delving beyond the limits of limited liability to potentially hold the shareholders liable for any debts.
This can occur when a company states they are unable to pay an agreed-upon expense, such as rent or legal costs associated with a lawsuit and the company has not been operating as a separate entity from the individual. The individual will attempt to hide behind the company to evade personal liability for the actions they take on behalf of the company. Typically, these companies are identified by being undercapitalized, having daily involvement by a parent company or not meeting corporate formalities. The company and individual may be comingling their assets and liabilities, which is the equivalent of treating the company’s money as their own.
With these matters, documentation and communication are the most important parts of understanding the operations of the respective entities. Explaining why certain documents are important, and what they show, can be difficult to communicate to non-accountants. People without financial backgrounds may not understand how individual transactions are expected to occur in the company’s regular business or if something questionable is occurring. Many companies have loans with shareholders/directors, and they may even pay them for different services. Money being passed in this manner may not necessarily be comingling; however, it is certainly something that needs to be examined in more detail.
The main question to ask when examining a piercing-the-corporate-veil matter is: Does the company have transactions with the subject individual/related parties where the subject individual has control? Then, a subsequent question: Are the transactions being treated properly or is it comingling?
Gather Documentation
The most important documents or information required in these types of cases are the underlying accounting records, specifically the general ledger. Financial statements, such as balance sheets, show whether loans exist between related companies or shareholders. Companies are permitted to have loans and transactions from related parties, but they have to be handled at arm’s length and recorded properly. The transactions themselves are not direct evidence that comingling exists, but rather it is the treatment of those transactions that will determine if comingling exists. General ledger transactions show the nature of the loans and transactions rather than just seeing the account they end up in.
Audited financial statements with notes can provide important information as well. These statements should discuss related parties. But again, related-party transactions are not evidence.
Bank statements and supporting accounting records, such as invoices and checks, do not show how the company is recording their transactions. However, with the general ledger, one can connect the bank statements and supporting accounting records to the related transactions to show that they are either appropriate or support comingling. Having transfers between the company and individual is not evidence, but rather a caution flag.
Analyze Records
Assuming the general ledger has been provided, it is now time to analyze the records. Are the records showing comingling and improper accounting, or are they showing that the companies or individuals are being treated as separate entities? Comingled entities might show money coming in and going through accounts that close out at the end of each year.
For example, if a bank account that is linked to the individual keeps having money from the company going in and out of it, there would be questions related to the nature of those transactions. Are they related to a loan or is it because the individual needs money? In other words, is it legitimate business activities or comingling?
In any matter, communication is key. If something looks questionable, it is not necessarily a red flag, more like a yellow flag that requires more investigation. Just because a company has a relationship with a related party does not mean they are comingling funds; it is just something to investigate further. The treatment of the transaction is more telling than the underlying relationship.