When you establish a company by forming a limited liability company (LLC) or corporate entity, you are creating a separate legal entity. The entity 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 you and your personal assets — at least in theory. This is called “the corporate veil.”
However, if you, as the business owner, do not take steps to protect the corporate veil, you may no longer receive personal liability protection. “Piercing the corporate veil” is the common phrase used to describe this problem.
Thus, protecting the corporate veil should be of utmost importance to business owners. In this article, we’ll cover everything you need to know about the corporate veil. We’ll outline what it is and what you need to do to avoid “veil piercing” so that you can protect your personal assets.
What is the corporate veil?
According to the Business Dictionary, the corporate veil is “a legal concept that separates the personality of a corporation from the personalities of its shareholders, and protects them from being personally liable for the company’s debts and other obligations. This protection is not ironclad or impenetrable.”
The definition continues, “Where a court determines that a company’s business was not conducted in accordance with the provisions of corporate legislation (or that it was just a facade for illegal activities), it may hold the shareholders personally liable for the company’s obligations under the legal concept of lifting the corporate veil.”
So essentially, the corporate veil is the liability protection that owners, corporate officers, and corporate shareholders receive when they form a limited liability company or corporation. In the United States, this applies to LLCs, C corporations, and S corporations.
The corporate veil is not relevant to sole proprietorships and general partnerships, as these business entities inherently do not have personal liability protection. The owners of sole proprietorships and general partnerships are responsible for business debts.
What is piercing the corporate veil?
Owners of LLCs and corporations are afforded personal liability protection. However, this protection is not guaranteed, nor is it a right. According to Cornell Law School, “‘Piercing the corporate veil’ refers to a situation in which courts put aside limited liability and hold a corporation’s shareholders or directors personally liable for the corporation’s actions or debts.”
This means that the liability protection afforded by LLC and corporate structures is limited. It’s not permanent and there are things a company can do to lose it by piercing the corporate veil. Once the veil is “pierced,” it’s very challenging for a company to recover.
What constitutes piercing the corporate veil?
Owners must continue to protect the corporate veil throughout the lifespan of the business by keeping business and personal assets separate.
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. This means that business assets must be kept separate from personal assets. Corporate owners need to have separate bank accounts and books.
Failure to keep separate accounts, thereby intermingling personal and business finances, is one of the quickest ways to pierce the corporate veil and expose your personal assets to risk. This may be more challenging for sole-owner businesses. An accountant can help you ensure that you keep your books clean and separate.
One of the other common reasons for piercing the corporate veil is small business owners failing to follow corporate formalities. For instance, some of the requirements of corporations are that they hold annual meetings of stockholders, keep minutes of board meetings, and maintain corporate bylaws. LLC owners don’t have such strict requirements, but they must do things like file annual reports with secretary of state offices and maintain operating agreements.
These are straightforward requirements for business owners to follow, but it’s easy to overlook them. Failure to abide by these requirements could expose a company to a piercing of the corporate veil.
What other actions could pierce the corporate veil?
Each state has different legal standards, but courts tend to look at a few common factors when determining whether the corporate veil has, in fact, been pierced. Here are some common mistakes that lead to a piercing of the corporate veil:
- The confused intermingling of business activities, assets, or management with personal activities and accounts
- Thin capitalization, which is a reference to the debt-to-equity ratio (If a company carries a lot of debt and very little capital, this could pierce the corporate veil)
- Nonobservance of corporate formalities, including the ones mentioned above like not hosting shareholder meetings
- Absence of corporate records including things like bylaws and operating agreements
- Insolvency at the time of the disputed transaction, which means that the company entered into a deal knowing that it would not be able to repay the debts owed
- Siphoning away of corporate assets by the dominant shareholders
- Officers and directors who don’t fulfill their obligations and duties as outlined in governing documents like the bylaws
- Use of the corporation in promoting fraud
No one single action controls the situation. Instead, it’s up to the courts to determine whether the veil has been pierced. The more severe the situation, or the more instances that occur, the higher the probability that the courts will rule in favor of piercing the corporate veil.
As you can imagine, this is more subjective than objective. Although it’s easy to interpret this as having “wiggle room,” the better way to look at it is by understanding you must be diligent in protecting the corporate veil, crossing all your t’s and dotting all your i’s. So what can business owners do to protect their corporate veil?
Protecting the corporate veil
As mentioned, the easiest thing to do to protect the corporate veil is to maintain a clear separation between business and personal activities. You should not do things like purchase personal products with business credit cards.
Another way to protect your company and protect the corporate veil is by keeping a thorough paper trail. You should keep receipts of all transactions, invoices, and other relevant documents. You should also maintain detailed records of things like meeting minutes and bylaws.
Keep this information in a safe space that’s easy to access. You should consider keeping a digital backup as well. The documentation should be detailed and accessible so that you can explain any transaction, no matter how long after it took place.
Other ways to protect your company include:
- Have a business plan or goal statement that shows how you plan to grow the company.
- Have enough money in your business account to cover current transactions and liabilities.
- Never finance your business from a personal account.
- Make it known whether you’re operating as an LLC or corporation
- Maintain records of all filings you submit to your Secretary of State’s Office
If you find yourself being sued, the plaintiff will be attempting to pierce, or lift, your corporate veil. As we’ll detail below, it is beneficial in these cases to hire an attorney.
However, the more important thing is that you make attempts to protect the corporate veil before accruing debts. Hopefully, with sound financial management, you’ll never run into a situation where someone attempts to pierce your corporate veil.
But on the chance that the day comes, you’ll be much better off if you kept diligent records and followed corporate compliance.
When to hire an attorney
When it comes to protecting the corporate veil, hiring an attorney is likely in your best interest, especially as you begin to conduct business in other states. Different states have different laws regarding the corporate veil. It’s common for business owners to assume one thing and practice another, which would then pierce the veil.
We recommend forming a relationship with a law firm upon first registering your business. This relationship will provide ongoing counsel from somebody who knows your business. Law firms will not only help with protecting the corporate veil, they can also help with things like reviewing contracts and chasing missing payments.
Once a claim against your company has arisen, it’s practically impossible for you to go back and “sure up” or “protect” the veil. After a claim, attorneys can only work with the facts that exist, which could expose you and other owners to a piercing of the veil.
The good news is that, according to Cornell, generally speaking, courts in the United States have “a strong presumption against piercing the corporate veil, and will only do so if there has been serious misconduct.”
So the good news is that courts are not looking to pierce the corporate veil. But that doesn’t mean it’s something you should take lightly. When it comes to protecting the corporate veil, it’s better to be proactive than reactive. Hiring a reputable law firm sooner rather than later is in your best interest.
The corporate veil is vital to personal assets
As a small business owner with an LLC or corporation, protecting the corporate veil is of the utmost importance. One of the most significant benefits of these types of business entities is that they provide personal liability protection to owners, officers, and shareholders.
In fact, personal liability protection is likely one of the primary reasons you chose this type of business structure. However, efforts to protect this corporate veil must be ongoing. It’s not a one-time, all-encompassing protection. Owners must make efforts to protect the corporate veil during the entire lifespan of the business entity.
Business owners should research the things they need to do to prevent piercing the veil and maintain personal asset protection. Consulting an attorney could be in your best interest, as he or she could walk you through the specific requirements needed to protect the veil in each state in which you operate.