Focus on the Initial Capitalization

April 13, 2006

	Visited: 169
	Not rated
	Rate:

The undercapitalization theory is one of two ways a court can pierce the veil of limited liability that protects an owner from liability for the business's debts.

Courts examine the capitalization of the business at the time it was formed. Thus, the initial capitalization also should be the focus of the business owner. Further, because the holding entity will have no direct operating activities, the focus here should be on the entities exposed to liability--namely, the operating entities.

Court decisions establish that if an entity subsequently becomes underfunded because of events unanticipated at the time it was formed, the undercapitalization theory will not apply. This is due to the fact that, in this theory, the creditor must prove fraudulent intent on the part of the owner. This will be lacking when the initial capitalization was reasonable, in relation to the entity's anticipated capital and operating needs.

Thus, before forming the business or beginning operations, the small business owner should prepare a capital budget that projects the business's need for equipment, furniture, supplies and other capital assets. The owner also should prepare a forecast of anticipated operating revenue and operating expenses for the first year, on a quarterly basis. Consideration should be given to financing any anticipated shortfall in this operating budget, along with the capital needs of the business.

Adequately financing the entity means supplying the entity with capital that does not fall significantly short of its anticipated needs. Financing the entity adequately does not mean contributing the anticipated capital and operating shortfall in return for an ownership interest in the entity. Court decisions have established that funding the entity with debt (i.e., leases and loans) is a legitimate business practice. In fact, in most cases in which the undercapitalization theory has been invoked, there has been a complete failure to adequately capitalize the entity with equity or debt.

Nevertheless, it would be a mistake to finance the entity entirely with debt. The owner must take back an ownership interest (in funding the business, the small business owner should follow the guidelines outlined in our discussion of using operating and holding companies).

There, a mixture of equity and debt financing is recommended. The debt component can represent 30 through 70 percent of the capital contributed. A higher debt component may be justifiable, but unnecessary. Assets contributed for the equity interest can subsequently be encumbered with liens that run to the holding entity or the owner. These liens will adequately protect the asset contributed in return for an ownership interest.

In short, it is important to adequately fund the entity to meet its anticipated capital and operating needs. This can be done with a combination of equity and debt financing. The assets contributed for the debt portion through leases and loans will not be vulnerable because the owner (or the holding entity) will assume the role of a creditor. The assets contributed for the equity interest will be encumbered with liens that run in favor of the owner or the holding entity. These assets will be protected as well.

Thus, adequately financing the entity does not mean the capital contributed has to be vulnerable to the claims of the business's creditors.

Courts have specifically approved of the use of a holding entity, which owns most of the business's assets, and a separate operating entity, which conducts the business's activities and is funded primarily through leases and loans.

In one case, a court refused to pierce the veil of an operating corporation under the undercapitalization theory, even though most of the business's assets were owned by a separate holding entity. At stake was liability for a series of promissory notes in default.

The court reached this conclusion even though the owner personally testified that the operating entity was grossly undercapitalized, and that the operating entity depended entirely on the resources of the holding entity.

The court ruled that the plaintiffs misconstrued the owner's testimony. The court found that there was a legitimate business purpose behind the arrangement. Because the holding company owned the assets, creditors could rely on the credit of the holding entity through personal guarantees from the holding entity, for example. Thus, it was unnecessary to place ownership of most of the capital within the operating entity. In short, there was nothing fraudulent about the arrangement. Absent any fraud, the undercapitalization theory will not apply.

Of course, all arrangements between the holding entity and the operating entity, including the establishment of the equity interest in the operating entity, and lease and loans arrangements, should be authorized and in written form.

In addition, the focus on the initial capitalization also means that unanticipated capital needs, operating expenses, or losses in revenue should not invoke the undercapitalization theory--even if future capital becomes inadequate, and the owner continues to receive payments for salary, leases and loans made to the entity.

In one case involving a car dealership, the court refused to pierce the veil of a corporation, even though the business's growth meant that the entity became significantly undercapitalized. The court ruled that the capitalization, at the time the business was formed, was the relevant consideration. The court found that, at the time the business was formed, it was adequately funded. Subsequently, due to significant growth, unanticipated at the time the business was formed, additional capital became necessary. A failure to provide this additional capital was not fraudulent. Thus, the undercapitalization theory was inapplicable.

The court also ruled, consistent with the general rule discussed above, that withdrawals of assets for legitimate business purposes by the owner (here, a withdrawal of $250,000 occurred) are not fraudulent, under the undercapitalization theory, even though they leave the business undercapitalized.

This ruling was made even though the owner testified that he withdrew the $250,000 to cover operating expenses in another entity he owned, because that entity was experiencing financial difficulties. The court concluded that the withdrawal was motivated by a legitimate business purpose, and not by an intent to defraud the car dealership's creditors.

The same conclusion could have been reached had the payments been made to the owner for salary, leases and loans, especially if these were ongoing payments, made pursuant to authorized and written agreements.

Note that all arrangements between the owner and the entity (or between entities) should be authorized in the form of written agreements.

In making withdrawals from the business, the owner must be cognizant of the fraud restrictions imposed by the Uniform Fraudulent Transfers Act (UFTA). The small business owner must also be aware of separate rules in state LLC statutes and state corporation statutes that regulate payments to the owner on account of his ownership interest, such as distributions of earnings, dividends or ownership redemptions.

Work Smart

Remember that roles can be reversed. At times, the small business owner may be a creditor who is owed a significant sum of money by a debtor who has defaulted.

The small business owner should rely on principles presented in this section (as well as in the discussion on limiting liability for contracts and torts) when acting in the role of creditor.

Thus, the small business owner should be protected in this instance because he will have required the other party to personally guarantee his entity's debts.

In addition, the small business owner, armed with this information, may be able to pierce the veil of limited liability, in the event there has been no personal guarantee, and in this way hold the debtor personally liable for the debt.