Piercing the Corporate Veil
- Last updated on . Written by Offshore Protection.
One of the primary beneficial features of a Limited Liability Company (LLC) and Corporation is that they both protect the beneficial owners from personal liability for the debts and obligations of the company. In other words, if you are the owner of an LLC, your personal assets should be protected if the company is sued or goes bankrupt.
However, there are rare cases where a court may in fact hold an LLC or corporation’s owners personally liable for the obligations of the company. This is known as “piercing the corporate veil”.
Table of Contents:
- What is ‘Piercing the Corporate Veil’?
- When Can Courts Pierce the Corporate Veil?
- More Specifically, Courts Can Pierce The Corporate Veil If One Or More Of The Following Criteria Are Met:
- How Businesses Can Avoid Being Piercing the Corporate Veil
What is ‘Piercing the Corporate Veil’?
The Corporate Veil is a term used to describe the legal separation between a business and its owners. It is a central concept in the corporate world, as it is what ultimately protects business owners from undue risks and liabilities faced by the company that they own.
In certain cases where specific conditions are met, a court may be able to “pierce” this corporate veil, and thus hold the owners of a company personally accountable for the business’ liabilities. This means that creditors will be able to directly claim against the owners’ personal assets such as their home, personal bank account, private investments, and other assets so as to satisfy the corporate liability.
It is important for business owners to familiarise themselves with this concept, and understand when they might be at risk of having the corporate veil pierced.
When Can Courts Take Action?
Broadly speaking, courts may pierce the corporate veil in one of two situations:
- When owners of a company fail to adequately treat the company as a separate business entity.
- When the owner of a company uses their control over it to commit fraudulent or illegal actions.
More specifically, courts can pierce the corporate veil if one or more of the following criteria are met:
1. The company and its owners are not genuinely separate
This can happen if the owners of a company do not maintain a formal legal separation between the financial activities of the business and their own personal finances. In other words, courts may find that the LLC is merely being used a guise through which the owner conducts their own personal financial dealings, and that the owner is behaving as if the company does not exist in reality. An example would be when the owner pays for their own personal bills or liabilities with the company’s accounts.
2. The owner uses the company for wrongful, illegal, or fraudulent acts
If the owner of a company knowingly uses it to commit wrongful or illegal acts (such as intentionally not repaying debt, committing financial fraud, etc.), the court may be able to pierce the corporate veil and hold the owner personally liable for the wrongdoings.
3. The company’s creditors were faced with an unfair loss
This only applies if one or more of the above factors are present. If someone who dealt with the company is left with an unsettled payment or bill, and the aforementioned criteria are met, it provides additional reason for courts to pierce the corporate veil and hold the company owners accountable.
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In addition to these criteria, the following two factors being present may provide additional rationale for a court to be able to pierce the corporate veil:
1. If the owner has failed to adequately capitalise/fund the company
If the owner has failed to adequately capitalise/fund the company so that it is able to cover all of its liabilities. This is not cause in and of itself to pierce the corporate veil, but it may contribute to the decision if the previous criteria are also met.
2. If the owner fails to follow corporate formalities
If the owner fails to follow corporate formalities such as keeping proper corporate records, fulfilling filing and compliance requirements, etc. While this may be common in smaller business due to lack of resources and expertise, if it is done in conjunction with the aforementioned factors, it can add to the case for piercing the corporate veil.
How Businesses Can Avoid Action Being Taken
Clearly, business owners should make sure they take the necessary steps to avoid a piercing of the corporate veil, otherwise they may find themselves with serious liabilities that they are unable to personally afford.
The main steps which should be taken include:
1. Maintain all necessary corporate formalities
These differ slightly depending on whether you own a corporation or LLC:
Corporations have stricter formalities to adhere to, such as to maintain bylaws, issue shares, maintain stock transfer ledger and other financial records, undertake annual financial filings and audits, pay corporate taxes and filing fees, etc.
LLCs need to undertake any annual filings that are required by the state and pay the relevant fees, submit taxes, maintain the operating agreement, keep a membership transfer ledger, and hold annual member meetings.
2. Document all business activities
You should keep thorough records of all major business activities and decisions. This includes signing and keeping all contracts that the business enters, keeping formal documents on record, maintaining meeting minutes of annual shareholder/member meetings.
3. Keep business and personal assets separate
One of the most important ways to avoid a piercing of the corporate veil is to make sure that all personal and business assets are kept completely separate. There should be a separate corporate bank account and credit card that is only used for business expenditure. All equipment and property should be kept separate, and recorded as such.
4. Make the corporate status clear
This means that you should make it very clear that all actions performed by or on behalf of the business are indeed in the business’ capacity. Purchases and invoices should have the company name on them, and all documents should be signed in the company’s name, never in your personal capacity.
5. Ensure the business is adequately capitalized
It is important that you don’t give the courts cause to accuse you of negligently not running the business properly or adequately funding it so that it can meet its obligations. As such, you should run the business in a responsible way and make sure that it has adequate capital to meet its obligations. This is important both for the business’ continued survival and success, as well as to avoid a potential accusation of negligence which could ultimately contribute to a piercing of the corporate veil.
In most ordinary circumstances, an LLC or Corporation will provide adequate protection to its owners. The limited liability nature makes it extremely difficult for courts and creditors to go after the personal assets of owners. However, it is still important to recognise that this layer of protection is not completely fool proof. There are indeed specific circumstances in which a court is able to “pierce the corporate veil” of protection which results in owners being personally exposed and liable. While this only happens in rare and exceptional circumstances, business owners should understand the risks and make sure that they do not expose themselves to them out of negligence or ill intentions.