When running a business, it’s natural to focus on your customers, team, and revenue. However, other underpinnings also require mindful management. One of those, if you’ve opted for a corporate structure or Limited Liability Company (LLC), is to ensure you’re not piercing the corporate veil. But what does that mean, exactly? Here’s a closer look at what the corporate veil is, how it can be pierced, and 5 steps you can take to protect yourself.
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What is the corporate veil?
A corporation is an independent legal entity that the law considers separate from its owners. As a result, corporate officers, shareholders, and investors have limited liability — they aren’t personally responsible for company debts or liabilities. That protection is referred to as the corporate veil.
For example, if a corporation goes bankrupt, the company’s assets would be liquidated to satisfy its debts. However, a corporate shareholder’s personal assets like their home, vehicle, and personal bank account, would be protected behind the corporate veil.
Which types of businesses does the corporate veil apply to?
The corporate veil applies to businesses that are structured as corporations or limited liability companies (LLCs). It doesn’t, however, apply to business structures such as sole proprietorships or general partnerships that don’t distinguish between the owners and the businesses.
What is “piercing the corporate veil”?
Piercing the corporate veil refers to a situation where a corporation or LLC is involved in a court case and the court decides to put aside limited liability. As a result, the owners, members, or shareholders of a corporation can become personally liable for corporate debts.
Continuing with the above bankruptcy example, if the veil is pierced, then an owner’s personal assets could be seized to cover the business’s outstanding debts. Beyond bankruptcy, liability can come into play when corporations are sued or when they default on debts.
The piercing of the corporate veil occurs most often with closely held corporations like small businesses because they are less likely to understand or follow the required corporate formalities, according to Miller Law.
How does the corporate veil get pierced?
In many cases, courts won’t allow for the piercing of the corporate veil unless serious misconduct has occurred, according to Cornell Law School.
But what kind of misconduct?
The laws that govern corporations are set at the state level so they can vary from one jurisdiction to the next. However, here are a few common causes.
Commingling of personal and corporate assets
One of the common culprits that leads to the piercing of the corporate veil is the intermingling of personal and corporate assets. In other words, you use personal funds for your business or business funds for personal purposes. There are many ways this can happen, such as:
- Using your business bank account to pay for personal expenses like rent or bills.
- Using a business credit card for personal expenses or vice versa.
- Getting a personal loan or business loan with a personal guarantee and using it to fund your business.
Corporate formalities require that corporations have dedicated business bank accounts.
“You need to maintain the books and records of the company separate from your own personal assets. This would include separate bank accounts and credit, making sure that company money goes into the business bank accounts, and then properly documenting expenses,” says Kimberly DeCarrera, Esq., a corporate lawyer at DeCarrera Law.
Do business loans with personal guarantees pierce the corporate veil?
Many lenders of business loans and credit cards today require a personal guarantee or base approval on an owner’s individual credit reports. In these cases, borrowers sign up to take on personal liability for business debts and thus forfeit their limited liability protection for that debt.
But can that lead to personal responsibility for other corporate debts? It could. If you find yourself in a court case where the plaintiff is trying to pierce the corporate veil and hold you accountable for corporate liabilities, evidence of personally-guaranteed business credit accounts could work in their favor.
Undercapitalization at the time of incorporation
Undercapitalization refers to a situation when a business doesn’t have enough money to pay its creditors and conduct business as usual. If you form a corporation without enough money to fund your operations, it can put your corporate liability shield at risk. While undercapitalization often won’t necessarily be reason enough on its own to justify veil piercing, it’s a commonality among cases that courts will likely take into consideration.
Fraud or wrongdoing
The corporate veil can also be pierced if the owners of a corporation use the entity to perpetrate fraud or wrongdoing for their own personal benefit (and it can be proven). Here are two common examples of how that can play out.
Alter ego theory
Many veil-piercing cases are based on the alter ego theory which suggests that a corporation and its owner are not actually separate. In this case, the corporation only functions as an individual’s alter ego to help them avoid accountability or obligations.
Single business enterprise theory
Similar to the alter ego theory, the single business enterprise theory suggests that a corporation is structured and organized for the sole purpose of being a tool that helps another corporation avoid accountability or obligations.
For example, a corporation could close down and reemerge as another company with the same office, staff, and offerings in an effort to avoid paying a debt to a creditor. Another example could be a parent company with a subsidiary that doesn’t truly function as a separate entity. Red flags can include shared corporate records, offices, employees, and payrolls.
In short, when corporation owners commit fraud or wrongdoing, claimants may seek to pierce the corporate veil to hold them accountable. And, according to Hendershot and Cowart P.C., “It is often easier to pierce the corporate veil in tort actions and matters of a statutory liability than it is in contract claims.” (Do note that they are talking about Texas law specifically, and laws may vary by state).
Other reasons the corporate veil can be pierced
Aaron Goldhamer is Attorney at Law at Keating Wagner Polidori Free, and has handled various cases that involve piercing the corporate veil. Along with the above reasons, he also mentioned a few other ways the corporate veil can get pierced, including:
- The corporate entity does not maintain typical or required records and minutes.
- The corporate entity does not maintain legal formalities.
- The nature of the corporate entity's control and ownership (typically, if ownership and control are concentrated with one person or other entity). For example, not having a board of directors.
Overall, it’s important to be aware of and follow all of the corporate formalities in your state.
What if I accidentally did something to pierce the corporate veil?
If you did something that could be used in a courtroom as grounds to pierce the corporate veil, you can’t undo it. However, you can work to protect yourself going forward. A good first step is learning the ins and outs of corporate formalities. Work to gain a thorough understanding of what’s required to insulate yourself and retain your limited liability protection. Then, if keeping the corporate veil in place is a top priority, move forward and follow all of the rules to a “T.” If you have any questions or concerns, seek legal advice from a trusted law firm that specializes in corporate business.
5 steps to prevent the piercing of the corporate veil
How can you help to prevent a court’s ability to pierce your company’s corporate veil? Here are five key tips:
- Ensure your reasons for establishing a corporation or LLC are legal and don’t cause harm to any third parties.
- Open a dedicated business bank account.
- Ensure you have enough money to fund your business operations from day one.
- Don’t intermingle personal and business funds.
- Build business credit so you can get credit accounts based on your business credit alone.
Goldhamer also recommends maintaining and abiding by your articles of incorporation and bylaws, and maintaining typical or required records (such as shareholder records, accounting records, etc.) and minutes of meetings.
Protecting your personal assets from corporate liabilities will take a bit of planning and discipline. Often, the reason for the commingling of personal and business finances comes from a place of necessity rather than ill intent. For example, when a person doesn’t have enough money to cover their personal expenses, they may turn to their business account for help. Further, if a business can’t get approved for a business loan, the owner may resort to a personal loan instead. While understandable, these steps can put you at personal risk so should be avoided when possible.
How this connects to business credit
Using business credit for your business can also help keep your business and personal finances separate, especially when you don’t personally guarantee your credit accounts and funding. Like personal credit, business credit reflects how well an entity manages its credit accounts. If your business pays its bills on time and keeps its credit utilization down, it can earn the trust of lenders.
So where do you start? It can be hard to get a business credit account when you’ve never had one before. A good entry point is a secured business credit card that reports to the three main business credit bureaus. After a few months of responsible use, you can be on your way to a variety of business loan options that don’t require personal guarantees.
Want more info on business credit? Check out these blogs...
- How to apply for a business credit card so you’ll get approved.
- Best business credit cards for building credit
- How to establish a credit file for your business