The #1 reason to form a legal entity is to limit personal liability for your business’s debts and obligations. If disaster strikes, you might lose your investment in your corporation or LLC. But with limited liability protection, creditors (like lenders or successful plaintiffs in lawsuits) can’t come after your personal assets. That is…unless a court pierces the corporate veil.
What Is Piercing the Corporate Veil?
Courts “pierce the corporate veil” when they decide to go after a legal entity’s equity holders (“shareholders” in corporations and “members” in LLCs) instead of the legal entity itself. Despite the name, “piercing the corporate veil” can apply to LLCs too, not just corporations.
So, let’s say you own a barber shop. You’re a prudent barber, so you set up an S-corporation to operate the business.
One day, a famous movie star walks in for a haircut. You’re enthused — this is your chance to make your mark on Hollywood hair. However, after you’re finished giving the celebrity a reverse-mullet (and being very pleased with yourself), she sues you for ruining her hair, arguing that she won’t be able to get work for six months. You are no longer pleased.
You’re even less pleased when the court agrees with the movie star and finds you liable for grossly negligent haircutting. The judge awards the movie star $500k in damages. Now, your barber shop doesn’t have $500k in cash just lying around. In fact, the total assets of your business are valued at just $20k.
Under normal circumstances, your S-corporation might sell its assets and pay $20k to the celebrity. Your business would be bankrupt, but at least the corporation would shield you from personal liability. You wouldn’t have to sell your personal home, car, or stocks to satisfy the judgment.
However, in some cases, courts might throw your limited liability out the window and hold you — the business owner — personally responsible for your business’s debts and obligations. This is called “piercing the corporate veil.”
So, instead of letting you pay $20k and walk away, a court will order you to turn over personal assets to satisfy the movie star’s claim. Not ideal!
Why Would a Court Pierce the Corporate Veil?
Different jurisdictions have their own specific tests and requirements for piercing the corporate veil. However, courts generally decide to pierce the veil when it seems like the corporation or LLC is merely an “alter ego” of its shareholder(s) or member(s). That is, the businessperson and the business aren’t really separate entities.
The following four factors are some of the most common reasons why courts disregard the limited liability protection of a corporation or LLC and pierce the corporate veil.
1. You Don’t Follow Corporate Formalities
When you form a corporation or LLC, you’ll file organizational documents with your local Secretary of State. Plus, you should draft a solid set of internal governing documents — bylaws (for corporations) or an operating agreement (for LLCs).
These governing documents set the rules of the road for your legal entity, and should touch on the following:
- Voting
- Meetings
- Management
- Profits distributions
- Admitting new shareholders/members
- All sorts of other things
It might surprise you, but the state wants you to actually follow the rules you’ve made for yourself. Gasp!
So, if your corporation has three directors on the board, you should dutifully document board approval of major decisions. You should hold an annual meeting each year (even if it takes five minutes). You should honor the provisions in your bylaws or operating agreement.
2. Your Business is Undercapitalized
While courts don’t typically pierce the corporate veil for undercapitalization, it’s a factor they consider. If you run a business, you should keep sufficient assets in the business to cover problems that might arise.
For example, if you own a small insurance business, keep some cash (or other liquid assets) on your books in case you need to pay out a claim. Instead of siphoning off premiums into your own personal account, keep them in your business as reserves. In fact, mixing personal and business funds deserves its own subheading…
3. You Commingle Business and Personal Funds
A court will frown if you set up a legal entity but keep using your personal checking account for the business — this leads judges to think that the business is merely your “alter ego” instead of a separate legal entity.
Instead, after forming your corporation or LLC, head over to the bank with your formation documents (and a tax ID number) in hand. Open up a business checking account. Deposit all business revenues into the business checking account. Pay business expenses using the business checking account. Business checking account. Business checking account. Business checking account. Have I made myself clear?
You can always cause your corporation or LLC to distribute funds from business to personal accounts, so long as you follow the required corporate formalities in your bylaws or operating agreement. See the section on corporate formalities above.
4. You’re Committing Fraud, Running a Sketchy Scheme, or Generally Attempting to Bamboozle the Public
If courts get a whiff of fraud, they’ll be more likely to pierce the corporate veil. Veil piercing is a complex and flexible concept, and unfairness to the public can play a big role in courts deciding to destroy your limited liability protection. Fraud is bad. Don’t do it.
How to Protect Your Business’s Limited Liability
In summary, the following actions serve as your business’s armor, protecting you from the veil-piercing lances of courts and creditors:
- Set up a legal entity (here’s how to choose the right legal entity for you).
- Draft internal governing documents and follow the rules you create for yourself.
- Keep adequate capital reserves within the business.
- Open a business bank account and keep funds separate from personal accounts.
- Don’t commit fraud.
If you have any questions about how to set up, grow, or protect your business, feel free to reach out.
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