Every investor and business owner should understand the concept of “piercing the corporate veil,” because in this instance, ignorance could be costly.
When a company is established via a limited liability company (LLC) or incorporated as a C corporation or an S corporation, a distinct legal entity is created. Many of us are familiar with legal arguments that liken a corporation or other business to a person, in that the company has a personality apart from the personality of its owners or shareholders
Because this entity is separate and distinct from its ownership, if the business encounters legal or financial issues, theoretically, the ownership is protected from creditors. This liability protection, provided by your business entity, is called the corporate veil.
It’s a Veil, Not a Wall
A lot of business owners seek out the LLC or incorporated structure for the protection alone, but creating such an entity takes more than some paperwork and payment of a registration fee to the state. Receiving the protection of the corporate veil requires an ongoing effort, effort which most owners of large and profitable businesses find well worth the investment.
However, the corporate veil is not absolute. If business owners fail to protect the veil, they can lose their liability protection—this is called “piercing the corporate veil.”
A corporation is meant to keep business owners safe from some of the consequences of the activities of their business’s management, separating one’s personal life from the personality of the business. It’s not meant to be a front for shady dealings. Thus the law provides for ways around and through the protection that incorporation can provide.
The corporate veil can be pierced if a business does not behave in accordance with corporate law—this is why so-called “shell corporations” no longer offer protection to their ownership if it is found that they’re used as a cover for illicit activities. First and foremost, the business has to be properly formed with Articles of Incorporation or Articles of Organization, bylaws, a designated registered agent, an LLC Operating Agreement (if appropriate), as well as business licenses and permits.
State of Affairs
Keep in mind that a lot of this is based on state law—much depends on where a business is incorporated and where an individual resides. Some states are more protective of businesses and business owners, which is why there are so many companies incorporated in states like Delaware. Ideally, incorporating or forming an LLC will make a business more profitable, but if it is done incorrectly all of those benefits may be lost.
Creditors can lift or pierce the corporate veil if a court holds a business’s officers, directors, or shareholders liable for a company’s dishonest acts. They can in some cases then go after business owners or shareholders’ homes, bank accounts, investments, collectibles and other assets to satisfy a company’s debt.
Generally, the corporate veil can only be lifted or pierced if it can be shown that the defendant—in this case the owner or shareholder— is able in some way to exert dominant control over the business. This leaves small business owners particularly susceptible to litigation. A huge issue that almost always automatically allows the corporate veil to be lifted is any use of corporate funds for personal benefit, or personally guaranteeing payment for a corporation or LLC’s debts.
Behave Like a Corporation
But it’s not enough to just avoid crime, fraud and dominance—there’s an expectation that an incorporated business or an LLC will also conduct the appropriate activities and maintain the documentation necessary to achieve and maintain incorporated status throughout the duration of its existence.
In other words, if you are a corporation, then you should behave like a corporation.
I have been advising small business owners and professionals in the areas of personal wealth management, employer retirement plans and business continuation for over forty years. During that time, I have attended countless year-end meetings with the client, their accountant and attorney. On many occasions, I have heard the business owner client lament on the “onerous” amount of work the other professionals recommend they do in order to preserve their standing as a corporation, and therefore, the liability protection afforded under corporate law.
Some of the onerous work expected of corporations and LLCs includes:
Keeping accurate, up-to-date financial statements. Different states have different rules for keeping and maintaining corporate records.
Reporting and paying taxes.
Holding annual meetings with all shareholders (in many cases, the business owner is the sole shareholder).
Documenting the minutes from the annual meeting. Failure to document meeting minutes may be interpreted by the courts as an indicator of domination of the business by the defendant, allowing litigation to pierce the corporate veil.
Keeping the corporate minutes book orderly and up-to-date.
Maintaining a separate Employer ID Number (EIN) for the business.
Maintaining a corporate identity by clearly identifying the company status on all business communications and by signing all company documents in the owner’s representative capacity. Above all, make it clear that customers, vendors, suppliers and partners are working with a legal business entity, not an individual person.
Establishing and maintaining separate bank accounts for the business and maintain adequate capitalization. If a corporation or LLC is found commingling assets in an account with an individual’s funds or lacking sufficient funds to operate, a litigator or creditor can argue that it was not intended to be a separate entity to stand on its own, allowing them to lift the corporate veil.
Don’t Leave This to Chance
Where it gets tricky is that many small business owners do not have the staff to help in any of these onerous activities—not only are they more likely to run afoul of the domination prerequisite for lifting the corporate veil, but they are also more likely to have problems keeping up with all of the requirements. While I appreciate the difficulty, it’s critical to continue doing this work in order to maintain corporate status.
Failure to do so may be disastrous.
I have heard many corporate attorneys explain that a litigator or a creditor can pierce the corporate veil if the business does not act like a corporation.
I would suggest anyone who owns an incorporated business talk to a corporate attorney if they don’t already retain one. As a financial advisor, I would stress that it’s time and money well spent.