Protecting Your Assets

October 2016

With the New Year coming up it is a good time to look at your corporate practices to see if there are any you need to clean up so you don’t expose your personal assets to liability for corporate obligations. Many people think all you have to do is incorporate and you will protect your home and your personal possessions from corporate creditors. This is not true. You can incorporate, and still lose all your assets to corporate creditors. To get the “limited liability” everyone expects when they incorporate, you have to follow the laws of the state in which you filed your Articles of Incorporation. Most states, have the same basic rules:

  • Rule #1: DON’T COMINGLE CORPORATE FUNDS WITH PERSONAL FUNDS:
    • Keep your personal expenses and your corporate expenses and income separate. Set up a separate bank account from the beginning to help with your wealth management (check this out for further advice on that front). Put the money into the account that you will use to pay your lawyer for setting up the corporation and any other start up expenses. You can have journal entries made to fix mistakes, but you should never pay personal obligations out of your corporate bank account.
    • If you paid corporate expenses out of your personal account, prepare an expense report and submit it to the corporation with receipts attached for reimbursement.
    • If you want to take money out of the corporation, pay yourself a salary, bonus or distribution and pay personal expenses from that or other personal income.
  • Rule #2: DON’T MAKE ILLEGAL DISTRIBUTIONS.
    • Don’t make distributions if you don’t have enough retained earnings to cover the distribution. Your retained earnings is stated on your financial statement. For S corporations it is the amount in the Accumulated Adjustment Account. If your corporation has issued preferred shares, an additional analysis needs to be done.
    • Don’t make distributions if after the distribution your assets would be less than your liabilities.
    • Don’t make a distribution if the corporation will be unable to meet its obligations as they become due after the distribution is made.
    • Don’t make unauthorized distributions. (See Rule #3 below)
  • Rule #3: TREAT THE CORPORATION LIKE IT IS SEPARATE FROM ITS OWNERS.
    • Don’t make distributions without approval of the Board of Directors. In addition to approving distributions, executive compensation and bonuses should also be approved by the Board of Directors.
    • Don’t repay loans to yourself that are not properly documented. Dealers often make loans to their corporations and pay them back in lump sums. If you do not properly document the loan, the loan repayment could be treated as a distribution in an audit even though you treated the repayment as a non-taxable loan repayment. Make sure you have a promissory note for the loan amount that specifies interest and how the loan will be repaid.
    • Don’t make decisions on behalf of the corporation that require director or shareholder approval without formally documenting the approval. An example of this would be loaning money or borrowing money. In either situation the corporation needs to obtain the approval of its directors to the loan amount and the terms of the loan including interest rate and repayment terms. A promissory note and corporate resolutions need to be prepared to properly document the loan.
    • Don’t allow your corporation to prepay on a promissory note to you without approval of the amount of the prepayment by the Board of Directors.
  • Rule #4: DON’T MAKE DISPROPORTIONATE DISTRIBUTIONS FROM A CORPORATION. If you are the only shareholder, this is not a concern. If there is more than one shareholder, all distributions to shareholders must be in proportion to their respective ownership interests. Failure to follow this rule can not only subject shareholders to personal liability for corporate obligations, it can result in liability to other shareholders and can also result in loss of the S election for a S corporation resulting in corporate income tax liability on top of the taxes already paid. This could be as much as an additional 43.8% in state and federal income tax per year for each year audited after which a violation occurred.

Many of these rules are designed to give creditors rights against shareholders if these rules are violated,This can happen either by piercing the corporate veil or going after the corporation or the shareholders for fraud. Don’t fall into this trap. Review your corporate records at least once a year with your corporate counsel and accountant and make sure you are following the rules.

Please Note: This article is necessarily general in nature and is not a substitute for legal advice with respect to any particular case. Readers should consult with an attorney before taking any action affecting their interests.