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What is the Corporate Veil?
Business owners usually start a corporation or Limited Liability Company in pursuit of the limited liability it affords. Since corporations and LLCs are separate legal entities, their shareholders and members are shielded from personal liability for debts (unless they sign a personal guarantee with a lender) and other judgments against the business. In legal terms, this separation is referred to as the “corporate veil.”
What Happens When the Corporate Veil is Pierced?
Generally, shareholders are not liable for the obligations of the corporation or LLC. However, in certain circumstances, a court may find “piercing the corporate veil” necessary when the company’s shareholders or members acted fraudulently or recklessly. When the corporate veil is pierced, the limited liability is put aside, and the entity’s owners are held personally liable for the entity’s actions or debts. This typically occurs when a party can sufficiently demonstrate that the entity’s purpose was not to conduct business lawfully but instead act as a shell, or alter ego, for the owners.
When Can Shareholders be Sued Personally?
Although courts are usually reluctant to find shareholders or members personally liable for business debts, strong evidence of fraudulent activity and wrongful acts will avail the individuals to judgments. This is especially true for “closely held” corporations and small LLCs (businesses owned by only one or very few people).
Shareholders, officers, directors, or members can be held personally liable when there is no genuine separation between the company and those controlling it. Creditors of the business can pierce the corporate veil and seek judgment against shareholders individually if corporate formalities are not followed.
How to Avoid Piercing the Corporate Veil
Owners can avoid piercing the veil by complying with corporate formalities, such as creating and updating bylaws, holding annual meetings, and keeping accurate business financial records. For these reasons, it is also important to create and maintain separate personal and business bank accounts.
Owners can become personally liable for business debts by signing a personal guarantee on behalf of the corporation. The best way to avoid this issue is for owners to execute any obligations using their names and titles within the corporation. If owners do not include their appropriate titles in business transactions, the obligations will be associated with them individually.
Using the LLC’s business checking account to pay for personal expenses is another way to have the corporate veil pierced. This is considered commingling of funds and is a way some shareholders become personally liable if the business is sued. Similarly, if the member uses business assets for personal use, the veil can be pierced.
Another factor that courts examine is whether the entity adequately capitalized. A corporation is required to be initially funded in a way that will enable it to pay its financial obligations. If a corporation has never had any assets to its name, a court may find that a party is entitled to reach the shareholders’ personal assets. The adequacy of capital is determined at the time of formation. It is based on the business’s size and its anticipated expenses and liabilities in the early days of the company.