Jack DonaldDespite its name, the corporate veil is not only applicable to corporations. As a whole, the veil is designed to ensure a company enjoys the benefits of limited liability protections. This liability insurance keeps the creditors from pursuing the personal assets of a company owner.
Considering that limited liability is the main reason why LLCs are so popular, having the corporate veil “pierced” defies the entire point of this business structure. So if you run a company with limited liability protection or plan on forming an LLC, maintaining the corporate veil intact is of utmost importance.
The good news is, it’s not easy to force a court to compromise the corporate veil, but it’s nevertheless possible. There are a few instances in which this can happen, all of them fairly egregious but it still warrants a closer inspection.
Quick Note: If you’ve yet to form an LLC but don’t want to do it on your own, you can always hire service providers like ZenBusiness and LegalZoom to help you out.
What Is a Corporate Veil?
The fact that the LLC model is vastly different from corporations is common knowledge, but the concept of the corporate veil still applies here since the veil refers to liability insurances present in both corporate structures and LLCs.
In a corporate setting, a corporate veil describes the concept of separation of the corporation as an entity and its shareholders as individuals. This means that a shareholder, as a personality, cannot be held accountable for any litigation that involves the personality of the company.
In the context of LLCs, limited liability refers to the same protections the structure provides for an LLC member’s personal assets, including physical property, intellectual property, estate etc. If the LLC itself faces a lawsuit, none of the personal assets of the ownership group can be repossessed, and the only assets at risk will be those directly involved with business activities.
It’s important to remember that the veil is not foolproof insurance, and there are quite a few instances that could result in the veil being lifted or “pierced,” as it were.
Still, as long as you’re aware of certain conditions meant to reinforce the veil’s protections and avoid creating legal loopholes that would render your personal rights, possessions, and legal accountability on par with those of the company, you could effectively avoid jeopardizing your limited liability as a whole.
Why Would a Court Allow Your Corporate Veil to Be Pierced?
Although there is precedent for the piercing of the corporate veil, this is not exactly common practice for the United States courts as they won’t consider discarding limited liability without serious proof of misconduct.
The conditions for piercing the corporate veil vary depending on the state, but it’s safe to say that all of them provide reasonable justification for this ruling such as misuse of company assets, abuse of power, or fraud.
Often you may not even realise you put your company at risk of losing its limited liability in court, which is most commonly the result of under-informed LLC formation or improper maintenance. Let’s examine the three main conditions for lifting the corporate veil in greater detail.
Your LLC Is Not a Separate Entity From Its Owners as Individuals
In some cases, the court can pierce the corporate veil if the LLC in question is indistinguishable from the individual(s) identified as the owner(s) of the company.
Although single-member LLCs can be more vulnerable in this respect, multi-member LLCs and other LLC types are not at all immune to having their corporate veils lifted due to the conflation of identities of the entity and its owner(s).
When a business entity is proven to have been used as a ‘tool’ to conduct private business unrelated to the company in question, the court could technically hold that individual to vicarious liability as a principal.
So when a principal, who can be a natural or legal person, is held to secondary liability, they become bound by the respondeat superior doctrine to hold responsibility for the prosecutable acts committed by the agent, in this case, the LLC.
For instance, if the owner of a single-member LLC involves the assets of the company to conduct personal business, such as paying for mortgages or settling bills using the company’s debit/credit card or bank account, it would virtually render the identity of the owner and the company inseparable by proving the company to be the owner’s alter ego.
This could also happen if the owner failed to establish a distinct line between their personality and assets (bank account, address, SSN) and the LLC’s identity (business bank account, EIN, the articles of organization).
A Member Uses the LLC to Commit Fraud
For the sake of convenience, let’s group the somewhat related conditions for the veil piercing under the single umbrella term of ‘fraud’.
The complexity of the procedure of lifting the veil based on fraudulent actions depends on the state. The court could generally consider dropping the limited liability protections if the owners of the LLC have, under the fiction of its entity and for their personal benefit:
- participated in improper conduct;
- exercised excessive control;
- perpetrated injustice;
- committed fraud;
If an LLC owner uses the company to circumvent legal restrictions placed on them as a natural personal while pursuing personal agenda, the corporate veil can be pierced just as well as when an owner sets up a sham LLC to perpetrated fraud.
The worst-case scenario is facing the allegations of actual fraud, specifically an intentional act of fabrication, misrepresentation, or adulteration of truth as opposed to constructive fraud that occurs unintentionally.
The first type is premeditated and carried out without any regard for the truth or its suppression, while the second type implies the perpetrator had no deceptive intent. Keep in mind that even if you were not intentionally malicious, the lack of awareness does not exempt you from legal accountability.
Technically, negligence is also a type of fraud most commonly occurring in the context of PLLCs when professionals are sued for failure to uphold a standard of care. If a PLLC member is found guilty of negligence, the corporate veil can no longer protect them.
Creditors Are Damaged Unfairly by the LLC
As a rule, creditors cannot legally pursue the personal assets of an LLC owner through seeking individual court action. This changes when the actions of an LLC have caused unfair damages to the creditors, either directly or via an agent.
The corporate veil can technically be pierced when an LLC cannot pay the creditors due to undercapitalization or when it’s proven to be a sham entity formed to avoid debt liabilities.
Undercapitalization essentially means that a company cannot pay creditors or engage in general business operations due to insufficient capital.
It can often happen to new LLCs that fail to estimate the initial startup costs upon formation or large companies with poorly managed infrastructure and mounting credit debt.
When an undercapitalized LLC takes on more loans to pay what it already owes without managing to eventually generate enough cash flow, the risk of bankruptcy and dissolution escalates.
The bad news is, when an LLC faces insolvency or ends up dissolving altogether, the corporate veil won’t be there to shield its owners from creditor debt.
How Can I Avoid the Piercing of My Corporate Veil?
Preventing your LLC from encountering any of the issues listed above that could endanger your corporate veil requires utmost attention. As your business grows, exercise great care in monitoring all operations in order and learn to pinpoint when any of these conditions has the risk of occurring.
Follow the Law When Forming Your LLC
The main steps towards securing the safety of a corporate veil should be taken during the actual LLC formation process. It’s common for inexperienced entrepreneurs to leave the formation under-researched at the risk of missing out on quite a few crucial details which could lead to the courts piercing an LLC’s corporate veil.
Most states also impose different regulations on entity registration and maintenance, so be sure to check with your state’s requirements while forming your LLC if you want to keep the corporate veil in place.
The key aspect you should look into is correct drafting and submission of the Articles of Organization. Ideally, this document should include all relevant information regarding the identity of your LLC as per your state’s guidelines, and the form should be filed in compliance with state rules.
If you consciously avoid mandatory filing requirements and it comes up in your litigation, such action could be construed as negative fraud. Claiming ignorance also won’t help if you miss out on necessary formation steps unintentionally.
Stay Current on All Maintenance Requirements
There are far more to adequate LLC maintenance than simply filing your Articles of Organization. Although compliance requirements vary depending on the state of operation, they generally involve the consistent submission of your annual report and maintenance fee.
First and foremost, learn the exact maintenance requirements in your state. Secondly, try your best to update your articles of organization and resolutions whenever any substantial changes occur. This can be done by amending the documents.
Other steps that could help you secure your corporate veil include:
- Filing your annual reports on time;
- Making sure you cover all state fees on time;
- Registering your LLC’s DBA names with appropriate county recorder offices;
- Registering your LLC as a foreign entity when expanding to other states.
Keep Your Personal and Business Assets Separate
Intermingling your personal funds and the financial assets of your company is one of the main causes of the corporate veil being pierced. It’s vital to avoid using your business funds to cover personal expenses.
It works the other way around as well: do not involve your personal bank account in your business activities that will show in your LLC’s transactions.
Always keep a clear record of your transactions, specifically for every instance of subsidizing the LLC with your personal funds. The records should show that the nature of these transactions is contributory rather than personal, meaning you were not making transactions to escape liability.
Maintain a Detailed Paper Trail for Your Business
When it comes to keeping your personal assets separate, keeping detailed records is vital. No one actually does this, so writing down every detail of your LLC’s business life cycle is a great way to indicate its separation from you as an individual.
Keeping a detailed LLC record book that covers all transactions and meeting minutes will also help you minimize accounting errors and keep the company better organized.
Sign on Behalf of Your Company, Not as Yourself
This aspect concerns all LLC owners and managers. As an executive officer, you should always sign the paperwork as a company representative rather than in an individual capacity.
Always include the company name, your position in the LLC, and your signature. For instance, your signature on a contract should be more like this: John Smith, Director of Operations of ABC LLC,” rather than simply John Smith.
This is done to show that you as a person and your company do not legally share the same identity.
Adequately Fund Your LLC From the Beginning
As mentioned before, undercapitalization is a common problem with small companies that underestimate the initial costs of starting an LLC. The financial plan for your startup should be well-thought-out down to every little expense, including the funds that go into risk management.
When choosing between the options presented in the final financial assessment for the initial capital, you should always lean towards one of the higher estimates.
Of course, you can’t always ensure your company against unforeseen macroeconomic circumstances. But what you can do is choose a reliable permanent capital supported by a stable line of credit, so it’s preferable to avoid short-term credits.
What Types of Liability Does the Corporate Veil NOT Cover?
While the corporate veil can protect an LLC from many forms of liability, there are a few aspects in which it’s ineffective. Let’s look at some of them.
Taxation Issues
When it comes to tax structure, LLCs are classified as pass-throughs, meaning they are not subject to federal income tax as all profits and losses are filed through personal returns of the owners.
But adhering to this structure means that in the event of your tax account becoming delinquent, the corporate veil will not be able to protect you from liability. Delinquency in tax essentially means failure to pay it upon the due return date in which case the IRS is authorized to go after your personal assets in court.
Reckless Personal Acts
Protecting against cases of personal negligence and reckless conduct is not something the corporate veil is designed for. So if you are found guilty of reckless or negligent conduct while performing as an agent of your business, such as causing an accident due to poor judgment on your part, you will be held personally accountable.
Personal Guarantees
An LLC’s director of operations might occasionally need to vouch on behalf of the company. By making guarantees in a personal capacity rather than as a representative of the company will absolutely remove your personal asset protection.
Such guarantees may be necessary for leasing, taking large loans, or offering personal assets as a security deposit due to insufficient business capital.
Why Is the Corporate Veil Harder for Single-Member LLCs to Maintain?
Limited liability companies operated by a single individual are bound to intermingle with their owner’s personal activities in many respects.
It’s easier for multi-member LLCs to allocate responsibilities evenly, assigning specific roles to their owners and members.
Running single-member LLCs (SMLLCs) from your home and conducting all communications, transactions, and deliveries on your own means you are likely to use your personal information and credit cards. Let’s examine the conditions that could weaken the effectiveness of the corporate veil for single-member LLCs.
Commingling Business and Personal Assets
Many small business owners who run their LLCs by themselves tend to use their personal business account and other assets to conduct their business activities. This in itself is perfectly understandable since keeping it all in one place helps you keep track of your business actions.
Still, despite the hassle that comes with creating separate accounts for your LLC, it’s advisable to go through with it in order to maintain the clear financial separation between you and your business.
Keeping Up with Formalities
The importance of maintaining all your documentation in order cannot be overstated. What may seem like simple formalities could potentially save you in court in the event of debt liability litigation.
Even if you run a single-member LLC, it’s essential to file all documentation that reinforces your LLC’s status as a separate legal entity and further maintain your entity’s compliance as per state guidelines.
Unclear Legalities
Given how young the LLC structure is compared to other business types, the legal system remains somewhat mercurial regarding this entity type. The majority of existing business laws used in the current court system were meant for regulating corporate entities rather than LLCs.
Even though the laws have been adapted to fit the LLC model, it still mainly concerns the multi-member structure. As a result, the courts simply don’t know what to do with single-member LLCs when it comes to making decisions regarding the corporate veil.
In Conclusion
Assuming the corporate veil to be impenetrable is one of the gravest mistakes an owner of a limited liability company can make. Not to mention how vital it is to keep your corporate veil intact for single-member LLCs.
The work that goes into placing the necessary insurances in place may seem excessive, but the potential consequences more than justify it. Always approach the formation carefully and consult legal specialists in your state. This can not only help you save your limited liability protections but also protect your personal assets.
