Authorization and Documentation

April 13, 2006

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A small business owner should use any or all of a number of withdrawal methods available in order to reduce the amount of vulnerable funds within a business. Obviously, steering clear of the restrictions on these transfers is vital, and one of the best ways is through good recordkeeping.

Under the concept of piercing the veil of limited liability, creditors of the business entity seek to have a court impose unlimited, personal liability on the owners of the entity. One of the two theories that can form the basis for piercing of the veil is the "alter ego theory."

Under the alter ego theory, creditors must demonstrate that the owners of the entity have operated the business not as if it were a true separate legal entity, but instead as if it were merely another side (i.e., the "alter ego") of the owners. Thus, if applied, the theory means that the business will not be recognized as being separate from the owners, and accordingly the owners will have unlimited, personal liability for all of the business's debts.

The primary way to avoid this outcome is through proper recordkeeping and, in particular, by ensuring that all transactions between the owners and their business entity are authorized and documented.

Thus, all arrangements for salary should be based on a written salary arrangement, which is authorized and signed by the entity's management. Similarly, loan arrangements should be based on written promissory notes and security agreements, and lease arrangements should be based on written lease contracts. In the case of loans and leases, once again the agreements should be authorized and signed by the entity's management.

One final point should be made with respect to the issue of actual fraud and withdrawals from a business entity. The Uniform Fraudulent Transfers Act's actual fraud provisions will apply to all transfers from a business entity to its owners. Actual fraud, as opposed to constructive fraud, requires that creditors prove the transferor intended to defraud the creditors through the transfer. Thus, actual fraud is not automatic, but instead depends on the court's inferring intent from the circumstances of the particular case.

Courts will look at the regularity of the withdrawals and the amount of the withdrawals