Maximizing Asset Protection Through Use of Nevada Corporations and LLCs
We are commonly asked by our clients to form Nevada corporations and limited liability companies. However, when pressed, we often find that many clients do not fully understand what their responsibilities are with respect to a corporation or limited liability company after the entity is formed and they have commenced doing business. We are particularly aware of clients who have followed the current marketing trend of using a non-lawyer entity formation company that throws together a legal entity without any real guidance on how to operate that entity, or what the legal consequences are for failing to function within the requirements of the law. We have seen too many disasters arise from such situations. This article is intended to help simplify some of the most important issues a businessperson should consider when conducting business with these highly popular entity types and why it is so critical that any serious businessperson obtain advice and guidance from a real, licensed Nevada attorney.
II. THE BASICS
Nevada has some of the best laws and protections available in the entire country for its corporations and limited liability companies. Those advantages are the subject of wide-spread discussion in articles and marketing pieces – some fact and some (unfortunately) fiction. That said, most of our clients have already come to the conclusion that they want to incorporate in Nevada and some feel that having the Nevada entity is all they need to do in order to enjoy the benefits they offer. This is not true! There is much more to obtaining the asset protection benefits of operating a business under the form of a Nevada corporation or limited liability company than simply forming the entity and doing business under that entity’s name.
In order to maximize the benefits of the use of these entities and obtain as much protection as possible, one must avoid many pitfalls that business owners commonly fall into, particularly when operating small, closely-held businesses.
Nevada and its neighboring states, such as California (whose case law is very influential in Nevada courts) have very well-established bodies of law which describe circumstances in which a court may be inclined to allow a plaintiff (bringing a claim based on a tort, such as a personal injury or fraud claim, or a contract-based claim, such as a collection action) to pierce through the “veil” of protection generally afforded by a corporate entity and find personal liability for a principal or shareholder of that entity. Under similar principles, a plaintiff could be permitted to pierce through one entity to find another affiliated or sister corporation or limited liability company liable for the affiliated company’s acts.
The so-called “veil” of protection that exists for shareholders of corporations and, similarly, for members (owners) of limited liability companies, is a creature of state law that is premised in part on a policy of allowing business owners to have an incentive to operate a business and promote general commerce but operate that business through a separate “person” or entity (such as the corporate form), which separate entity (the corporation or LLC) is generally responsible for the acts of the business and its liabilities, as opposed to the business owners (the stockholders of LLC members) themselves. This arrangement is very attractive for business owners and highly recommended by legal counselors.
However, one must be aware of the limitations on the protections offered by these entities. In a prominent case in this area, the California Court of Appeals voiced a view similar to that adopted by Nevada courts, which is that:
A corporate identity may be disregarded—the “corporate veil” pierced—where an abuse of the corporate privilege justifies holding the equitable ownership of a corporation liable for the actions of the corporation. Under the alter ego doctrine, then, when the corporate form is used to perpetrate a fraud, circumvent a statute, or accomplish some other wrongful or inequitable purpose, the courts will ignore the corporate entity and deem the corporation’s acts to be those of the persons or organizations actually controlling the corporation, in most instances the equitable owners.
Sonora Diamond Corp. v. Superior Court of Tuolumne County, et al., 83 Cal. App. 4th 523, 538, 99 Cal. Rptr. 2d 824, 835 (2000). California and Nevada courts, thus commence the analysis of corporate veil piercing by asking whether the entity has acted as an “alter ego” of some other person (i.e., a shareholder or some other entity) in committing a bad act which damages another person, such that the corporate veil must be disregarded in order to remedy some injustice that cannot be remedied without disregarding the defendant’s desire to hide behind the corporate veil.
Similarly, a prominent Nevada Supreme Court case holds that, for a finding of “alter ego” in Nevada (i.e., for a plaintiff to get a court to allow it to seek to enforce a judgment against the personal assets of the business owner), “(1) the corporation must be influenced and governed by the person asserted to be the alter ego; (2) there must be such unity of interest and ownership that one is inseparable from the other; and (3) the facts must be such that adherence to the corporate fiction of a separate entity would, under the circumstances, sanction a fraud or promote injustice.” LFC Marketing Group, Inc. v. Loomis, 116 Nev. 896, 904, 8 P.3d 841, 846 (2000). Hence, very similar to California, in Nevada, a court will disregard the corporate form (and allow a plaintiff to pursue the personal assets of a business owner) in a situation where, for example, there is a person (or group of persons) exercising such control over the corporation (or limited liability company) that the person(s) and the corporation are – for all intents and purposes, inseparable – particularly where there has been some bad act commited which causes damage to a plaintiff.
By way of an example, an obvious case might involve a corporation where the principal shareholders raise capital from third parties for investment, but in actuality pocket the funds and return nothing to the investors, but then seek to utilize the sham corporation as a shield to their personal liability for this fraudulent conduct. Such a result would be inequitable and could only be remedied by piercing through the corporate veil to seek back from the defrauding principals the money they have defrauded their victims out of. Again, this is an obvious case – there are infinite variations of the application of this doctrine.
III. PRECAUTIONS EVERY BUSINESS OWNER SHOULD KNOW ABOUT AND ENSURE THAT THEY PAINSTAKINGLY FOLLOW
So what are the rules that a business owner should take pains to follow in order to make sure they can make the best possible arguments that they have properly maintained the corporate (or LLC) entity as a “separate” entity (and not as an alter ego of the business owner) if faced with an argument that their corporation’s veil should be disregarded? Cases supply a number of considerations that must be considered, as discussed below. To understand the specific application of any of these factors, legal counsel should be consulted.
1. Never commingle the funds or other assets of the business owner (or two separate entities). A misguided business owner, or inexperienced start-up owner, may fall into the trap of believing that the shareholders (usually a sole shareholder or handful of partners) of a small corporation or LLC can treat the money and assets of the entity as their own. This is a major (and common) mistake, and perhaps one of the most deadly in the terms of the alter ego analysis. Business owners that use entity funds for personal purposes (i.e., paying their own bills out of entity funds generated by the business or dipping into the company’s separate bank accounts for personal purposes) are disregarding one of the primary functions of the corporate (or LLC) entity – separateness.
The business must operate on its own, using its revenues to support its legitimate business operations in the ordinary course. Shareholders may take legitimate distributions of profit after the entity’s business expenses have been paid or reserved for, and should seek proper accounting advice in connection therewith (see section 2 below on the need for adequate capitalization). However, even a sole shareholder should not fall into the trap of dipping into the entity’s accounts without observing proper formalities for distributions of profit because even though they may not be harming anyone (such as a business partner), a future dispute could lead to a forensic accounting audit to ascertain whether the corporation (or LLC’s) separateness has been maintained. Those who commingle business and personal funds are at serious risk that such evidence will be used against them in an alter ego argument in court.
2. Ensure the Entity is Adequately Capitalized. Closely related to the foregoing element, a corporation or LLC must be adequately capitalized, meaning essentially that it must maintain sufficient capital reserves to cover the claims of creditors that might arise in the ordinary course of business, as opposed to diverting funds to shareholders and leaving the company unable to pay its debts as they come due. As indicated above, an entity may pay proper distributions and dividends from profits of the company to its shareholders; however, one key consideration is ensuring that the payments of such distributions does not leave the entity undercapitalized for its ordinary business operations.
The foregoing element is easy to describe in principle, but far more difficult to describe in practice. The amount which represents “adequate capital” is not strictly or clearly defined – in other words, there is no set formula that one may use to arrive at a figure the courts will accept in order to consider an organization as being adequately capitalized. As a result, many clients struggle to determine what it means to be adequately capitalized, given the tension between maintaining adequate capital, and paying distributions of profits to shareholders. This tension should be understood in the context in which it will be considered in court: just remember that the judge will usually be looking at this issue because a plaintiff is concerned that its judgment will not get paid from entity funds and assets, and it is looking for another pocket to collect from – your wallet and other personal assets.
While legal and accounting advice should be sought in these matters, two major guiding principles include the following:
- a. Ensuring that the business has adequate insurance to cover claims of potential tort claimants is fundamental. Where a potential claim is covered by insurance, an undercapitalization argument is far more difficult to make (and generally is not an issue). Consulting with an insurance advisor on a business’s insurance needs is essential.
- b. Strive to ensure that the business maintains positive working capital at all times. Working capital measures an entity’s ability to pay its obligations in the short term. Working capital is defined as an entity’s current assets less its current liabilities. “Current” generally refers to assets that will convert to cash, including cash, and liabilities such as bills due to be paid in the next 12 months. In this regard, it should be remembered that long-term subordinated debt (payable in over 12 months) to shareholders may generally be considered equivalent to capital. The working capital ratio is the current assets divided by the current liabilities. If current assets are equal to current liabilities, the ratio is 1.0. If the current assets are greater than current liabilities, the ratio moves in a positive direction. If the ratio moves in the negative direction, and the company is unable to obtain appropriate financing, it will quickly become insolvent.
- c. Strive to ensure that the business’ equity, also referred to as capital, is positive at all times. Equity of a company is its total assets less its total liabilities. Adequate capital denotes having greater total assets than total liabilities. If liabilities exceed assets, there will be negative equity and the company will be insolvent (again, if we assume no ability to obtain financing and inadequate insurance). If the only recourse to survival is to obtain funds from the shareholders, the defense to alter ego claims is still available despite an infusion of additional capital funds because the owners are permitted to contribute more capital to a failing company without creating alter ego liability. The company could, however, be subject to an alter ego attack if the owners take money out of the company to the extent that its equity becomes very low or negative. The difficult question is: by how much should the assets exceed the liabilities? In this regard, we note the following:
- i. The so-called debt-to-equity ratio for each business is typically defined as total liabilities divided by shareholder equity.
- ii. In order to determine an appropriate debt-to-equity ratio, one should consult with legal and accounting advisors. Banks typically have benchmark ratios, which they require for lending purposes. All of this information should be analyzed to arrive at an appropriate debt-to-equity ratio goal for each business.
In summary of this point, a business owner that is acutely interested in evaluating both a safe working capital level (or ratio) and a safe debt-to-equity ratio should – again – be mindful to consult legal and accounting advisors to find the appropriate target for the type of business engaged in. This may include, for example, an evaluation of governmental information, such as IRS corporate ratios data, for similar types of business, as well as financial benchmarks required by lending institutions. However, no advisor can give anyone a bottom line formula – at best, one can estimate a number that will give a client a good argument premised on objective data, if faced with an alter ego argument.
3. Ensure that Corporate Formalities are Complied With. This is a very important issue, and there are separate considerations in this regard for corporations and limited liability companies. The LLC is generally a simpler type of entity due to the fact that LLCs (unlike corporations) are not required to have annual board meetings or shareholder resolutions, they are not required to issue “stock”, and many of the formalities of the company are handled through actions of the LLC’s managers. Most LLC governance issues are handled in the manner described in a well-drafted operating agreement.
- a. LLC Operating Agreements – Have One. A note about operating agreements for limited liability companies – in this firm’s experience, this is one of the true shortfalls of the fact that so many non-lawyers are involved in the business of entity formation. Given the popularity of the LLC, we have reviewed more deficient and completely ineffective operating agreements than we care to remember – most of which are prepared by non-lawyers selling a client a “discount” start-up entity formation package. This may be a risk that a business owner without partners may be willing to take, but it should not even be considered by anyone where there will be more than one owner (in an LLC, a business owner is called a “member”, as opposed to a corporation, which has “shareholders” or “stockholders”) will be involved. All too often the business relationship breaks down, and, without an effective operating agreement where the members have thought through how the company will be run (i.e., such as who has access to company bank accounts? Who can spend company money? Who has to vote on major decisions?), and, as importantly, how disputes will be resolved, the matter ends as a “business divorce” in very costly litigation and permanently destroyed personal and business relationships. These divorces leave many people broke and devastated. What started as an exciting new business venture becomes a complete disaster. Do not let this happen to you. We have even seen business partners in these situations fighting over how much of the business each of them owns – a fundamental issue that should have been resolved and documented in a signed legal document at the outset.
- b. Other Formalities for LLC’s. In Nevada, aside from the fact that an annual list of “managers” (for manager-managed LLC’s) or “members” (for member-managed LLC’s) with annual fees is made to the Secretary of State, there are not many other formalities that need to be followed (aside from following the governance procedures described in the operating agreement) in a legal sense. It is often wise for the managers to have written resolutions documenting major decisions or company actions, just as with a corporation (described below), and in some cases, for example with financing, they may be required; however, these are less commonly used than in the corporation context. This is one of the key reasons clients vastly prefer the use of the LLC over the corporation. That said, whether the company is operating as a corporation (the formalities for which are described below) or an LLC, proper and complete accounting books and records should be maintained for each separate LLC.
- c. Proper Governance of Corporations. In the context of a corporation, corporate governance is performed by a board of directors and the corporation’s officers (in Nevada, a corporation must have a president, secretary and treasurer – which may all be the same person). Major decisions are made by the corporation’s directors. The day-to-day operations are conducted under the supervision of the corporate officers. As a result, the corporation must have a set of bylaws which should also be prepared by an attorney, which indicate the specific roles of shareholders (which elect the directors), the board of directors (which vote to elect the officers) and the roles of each officer, including the scope of their respective authorities.Making sure that a corporation is properly set up for the observance of these governance formalities is critical. One should remember, of course, that the mere election of corporate directors and officers is not enough alone if, in fact, the individuals elected or appointed do not actually fulfill the responsibilities typically associated with these roles. Where, for example, corporate directors or officers are nominally appointed in order to comply with legal requirements, but a dominant shareholder exercises actual control over the entity, these facts can be used to demonstrate that the corporation is not functioning with proper formalities if the dominant shareholders is, in fact, acting as an alter ego of the corporation.
- d. Maintaining Proper Corporate Resolutions and Having Board Meetings. Since corporations operate in a more traditional and rigid world than LLCs, with all major decisions being made by the board of directors, minutes of meetings of the board of directors are documented, and decisions are memorialized as “resolutions” of the board of directors. While Nevada law allows the use of written resolutions, signed by the board of directors, in lieu of an actual meeting of the board, these written consents should be documented and maintained in the corporation’s office minute book of records. At least annually, the shareholders and the board of directors must meet (or execute a written consent in lieu of an annual meeting), for such purposes as electing directors (by the shareholders) and officers (by the directors), approving major decisions (or ratifying decisions previously made) and taking care of other corporate business, such as the authorization of major actions. Major actions that should almost always be documented by resolution of the board may include the following:
- 1. lease transactions and renewals;
- 2. significant financing transactions;
- 3. the sale or acquisition of major assets;
- 4. the authorization of any distributions to the shareholders;
- 5. the authorization of any major expenditures;
- 6. the approval of any changes to the bylaws, and the reasons for any such changes;
- 7. entering into any major or significant contracts over a particular threshold dollar amount;
- 8. the annual election of officers (President, Secretary, Treasurer, etc.);
- 9. the approval of the company’s stock ledger statement; and
- 10. the authorization for the issuance of any new stock or changes in stockholders.
The bottom line is that corporate minutes should exist for at least every year of a corporation’s existence. This is almost always one of the most readily identifiable ways that a plaintiff’s attorney will try to show that corporate formalities were not observed.
- e. Issuance of Corporate Stock. Given the fact that a corporation’s owners hold “stock”, which stock is issued in the form of written securities (this can be done for limited liability companies, but often is not – rather, with an LLC, ownership percentages are generally documented in the company’s operating agreement), stock should be issued in the form of stock certificates, and a written ledger of all issued and outstanding stock of the corporation should be maintained. Cancelled shares should be documented as well and retained in the corporation’s stock records. This is a common pitfall for corporations – often when we review an existing corporation’s stock ledger for a new client, it is impossible to follow, and in a transaction involving the sale of corporate assets or stock, this can be highly problematic.
4. Make Sure that Separate Business Entities Stand Alone. In a similar vein with many of the issues described above, if a business owner uses separate corporations or LLCs as part of its overall business operations (which is often very wise where separate business operations will be undertaken), each entity must stand alone and be treated separately from the other entities, even if they are part of the same business operation. For example, a business owner should be careful about advising creditors that one of its (stronger) entities will stand good for the obligations of another (weaker) entity. Along these same lines, when considering whether an affiliated (or sister) company can be held liable for the actions of the other entity, a business owner needs to understand that a court may look at various issues to see whether these entities are really being treated as separate entities, or whether they are merely alter egos of one another, such as whether they use the same offices and employees, or the same officers and directors. This is not to say that the use of similar offices and staffing (or the same officers and directors, for that matter) is always taboo – however, legal counsel should be consulted about how to properly segregate these types of activities to maintain proper separation of the entities. The idea is to make sure that a sister company is not a mere shell or conduit for the business affairs of another entity.
One final thought in conclusion is this: when considering the foregoing alter ego factors in Nevada and any other jurisdiction we are familiar with, no one characteristic governs. As indicated, there is nothing inherently wrong with two entities having identical equitable ownership, or identical directors or officers. However, when these factors are present in a corporation that – for example – is clearly undercapitalized and there has been commingling of the shareholder’s and corporation’s funds, and/or other factors such as a complete disregard of corporate formalities, a court may well be inclined to hold a shareholder liable to a third party who has been injured by some bad act (such as fraud) of the corporation. Stated more succinctly, the Nevada Supreme Court has emphasized that “there is no litmus test for determining when the corporate fiction should be disregarded; the result depends on the circumstances of each case.” LFG Marketing Group, 116 Nev. at 904, citing Polaris Industrial Corp. v. Kaplan, 103 Nev. 598, 602, 747 P.2d 884, 887 (1987).
As a result, if one is truly serious about having a business entity that functions in the manner intended, so as to be able to take advantage of the full-range of asset protections afforded to these entities, legal counsel should be obtained and followed. Having a relationship with a lawyer who can answer questions as they arise on an ongoing basis is an important lesson for any start-up business to learn. It is simply a necessity of functioning in today’s legal climate. Make sure you are prepared for any legal issue that comes your way. Make sure you are well-advised by trusted legal counsel so that if y–Proper Use of Nevada LLC and Corporation Entit you are sued, you are in the best possible position to defend your case successfully.