A properly formed and operated corporation or LLC offers its owners limited liability for the debts of the business, so that their losses are limited to their investment in the business. In some extreme and rare cases, however, courts hold the owners liable for the debts of the company, including for judgments resulting from lawsuits. In legal terminology, this is called "piercing the corporate veil."
Courts normally pierce the corporate veil in situations where one owner or a small group of owners dominate the management and operation of the corporation or LLC. Without more, the combination of ownership and management is not a problem (indeed, LLCs are designed to be managed that way). The problem arises when one or more of the following factors are present:
- Misuse of Corporate/LLC Funds. Courts look at whether a dominant shareholder or owner treats the assets of the corporation or LLC as if they were his own. This could involve a shareholder or owner intentionally siphoning off company assets for personal benefit. Alternatively, it could involve a shareholder or owner co-mingling company bank accounts and records with her own, and failing to keep good records of transactions between the company and herself. To avoid veil-piercing liability, you should never cause your company to pay you an amount of money that will render it insolvent (meaning, that the company's assets are less than its liabilities or it is unable to pay its bills as they become due). Additionally, you should always maintain a separate bank account for your company and keep separate financial records.
- Undercapitalization. Courts also look at whether a corporation or LLC is undercapitalized. The exact definition of "undercapitalized" is not entirely clear, and the definition changes depending on the nature of the business. However, it is clear that you should never intentionally keep your company in a state where it lacks the assets necessary to pay its creditors. On the contrary, you and the other shareholders or owners (if any) should make a reasonable initial investment in the company. You don't necessarily need to put in so much money that you can cover all foreseeable needs or debts of the business (after all, businesses are permitted to take out loans, and they do so all the time), but you should invest enough so that you take on a "fair" share of the risks of business failure.
- Failure to Observe Corporate Formalities. Courts
sometimes consider the extent the owner or owners of a business have
disregarded corporate formalities. Among the types of conduct that
might constitute "disregard of formalities" are
- failure to issue stock;
- failure to have shareholder meetings to elect directors, or to hold director meetings, or to prepare minutes of these meetings; and
- failure to formally approve or carefully document transactions between the business and its shareholders or members.
- This factor generally is more relevant to corporations, because LLCs do not require the same kinds of operating formalities. However, in order to maintain their limited liability protection, LLC members should observe certain formalities, such as keeping detailed financial records and recording minutes of major decisions.
- Fraud. Courts also examine whether the dominant shareholder or owner uses the company to perpetrate a fraud or makes fraudulent representations about the business. As one commentator notes, this category can be seen as "a general catch-all prong which allows courts to disregard a legal entity when they feel like someone has complied with the letter, but not the spirit, of the law." This could involve making misrepresentations about the corporation's financial status, promising that the corporation will perform its obligations while knowing that this is impossible (or intending to do otherwise), or making representations that would lead a creditor to believe that someone, other than the corporation, stands behind a debt. But it could potentially cover much subtler forms of misrepresentation or wrongful conduct. As a practical matter, unless you intend to assume liability yourself, you should never make verbal assurances to creditors that you will pay the debts of the corporation if it is unable to meet its obligations. Most importantly, you should always be upfront and honest when communicating with creditors and/or clients of your business.
The presence of one or another of these factors does not automatically result in piercing the corporate veil. The analysis that courts perform is fact-intensive and unpredictable. The presence of two or more of these factors, however, would make it more likely that a court would disregard the corporate/LLC form and hold you personally liable for the debts of the business.
Note: No piercing of the corporate veil is necessary to hold you personally liable for your own unlawful actions, such as if you write a defamatory article or blog post. In that case, you are independently liable for the injury done. The LLC or corporation may also be liable, but a plaintiff could satisfy the judgment out of your personal assets should the company's assets prove insufficient.
Best Practices for Avoiding Piercing the Corporate Veil
- Never cause your corporation or LLC to pay you an amount that would render it insolvent, or any amount that would seem unreasonable to an outside observer. Document the justifications for large payments made to shareholders or members.
- Keep separate financial records for your business and yourself, and maintain a separate bank account for the business. Avoid borrowing money from the company for personal expenses. If you absolutely have to withdraw funds from the business, make sure that you keep accurate records of how much was borrowed and when you paid it back. Charge yourself a reasonable interest rate for the loan.
- Do not verbally assure creditors that you will personally take on the obligations of the corporation if the company proves unable to do so. Do not blend corporate and personal obligations.
- If you operate as a corporation, make sure to observe the required corporate formalities, such as issuing stock, holding shareholder and board of directors meetings, keeping adequate minutes for meetings, and formally approving and documenting any transactions between the company and shareholders. For more on required corporate formalities, see the Corporation and the Corporate Records sections.
- If you operate as an LLC, the same formalities are not required, but LLC members should observe certain formalities, such as keeping detailed financial records and recording minutes of major decisions.