Understanding the Corporate Veil and Protecting Yourself From Litigation
When you establish a company by forming an LLC or another business structure, you are creating a legal entity. It can enter into contracts, purchase goods and services, take on debt, and file litigation against others. Legally, it has most of the same rights and powers that you have in your personal life.
Because your business is a separate entity, if it gets sued, defaults on a loan, or declares bankruptcy, creditors can’t place a claim on your personal assets — at least in theory. This is called “the corporate veil.”
Piercing the Corporate Veil
The caveat: If a business owner does not treat his or her company as a separate entity, attorneys may attempt to lay claim to the owners’ personal assets if there’s a legal dispute. “A common problem with small businesses that leaves them open to claims of ‘piercing the corporate veil’ is failure to follow corporate formalities,” notes Massachusetts attorney Phil Taylor.
“Corporations large and small require annual meetings of stockholders and boards of directors and certain records to be maintained. Small businesses often fail to follow these formalities and recognize their importance.”
Knowing the Law
Each state has different legal standards, but Taylor points out that courts will consider whether any of these factors are present:
- Confused intermingling of business activity, assets, or management;
- Thin capitalization;
- Nonobservance of corporate formalities;
- Absence of corporate records;
- Insolvency at the time of the litigated transaction;
- Siphoning away of corporate assets by the dominant shareholders;
- Nonfunctioning officers and directors;
- Use of the corporation for unrelated transactions by the dominant shareholders; and/or
- Use of the corporation in promoting fraud.
No single factor controls the situation, but the more that exist, the higher the probability that attorneys can pierce the veil, Taylor says.
Taylor says that it’s crucial to maintain a clear separation between your business and personal activities. “Do not buy personal items using corporate accounts. Keep a paper trail so the money can be followed. If the business looks more like an alter ego of its owner, it’s more likely to be treated as such than as a separate entity.”
Other ways to protect yourself:
- Keep your records current and complete. Your documentation should be detailed enough that you can explain any transaction years after it took place.
- Have a business plan or goal statement that shows how you plan to grow the company.
- If you have partners or stockholders, keep detailed meeting minutes.
- Maintain a separate bank account for your business. (Never make personal purchases with business funds.)
- Have enough money in your business account to cover current transactions and liabilities. Do not finance your business from a personal account.
When to Hire an Attorney
Form a relationship with an attorney when you register your business. This relationship will provide ongoing counsel from somebody who has knowledge of your business.
Taylor says, “After the claim has arisen, it is often too late to make changes to operating practices. The attorney is left primarily to frame the defensive arguments based on the facts that exist… which may not be the best to support the arguments needed.”
Tim Parker is a business writer for Intuit and is passionate about solving small business problems.