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Piercing the Veil: Understanding and Avoiding Personal Liability for Your Business
Running a business comes with its share of risks and rewards. One crucial aspect that entrepreneurs and business owners must navigate is the concept of “piercing the veil.” This legal principle, while often overlooked, can have significant implications for personal liability and the financial security of business owners. In this article, we will explore what piercing the veil means, why it matters, and how you can take steps to avoid personal liability for your business.
What is Piercing the Veil?
The concept of piercing the veil refers to a legal doctrine that allows courts to disregard the legal separation between a business entity and its owners. Typically, when a business is formed as a separate legal entity, such as a corporation or a limited liability company (LLC), it is treated as an independent entity distinct from its owners. This separation is known as the “corporate veil.”
However, under certain circumstances, courts may disregard this separation and hold business owners personally liable for the debts, obligations, or wrongful acts of the business. Piercing the veil is a remedy that is invoked when a court determines that the business entity is being misused or abused to perpetrate fraud, injustice, or other wrongful actions.
Why Does Piercing the Veil Matter?
Piercing the veil matters because it can have significant implications for business owners’ personal assets and financial security. If a court pierces the corporate veil, it means that the protections afforded by the business entity’s separate legal status are stripped away, and the business owner’s personal assets could be exposed to satisfy business debts or legal liabilities. This could include personal savings, homes, cars, and other valuable assets.
Common scenarios where courts might consider piercing the veil include:
- Fraud and Misrepresentation: If business owners intentionally create a business entity to defraud creditors, customers, or other stakeholders, courts may pierce the veil to hold them personally accountable for their actions.
- Undercapitalization: If a business is severely undercapitalized at the time of formation and is unable to cover its financial obligations, a court might view it as a mere façade and hold owners responsible.
- Commingling of Assets: Mixing personal and business funds or assets without proper documentation can weaken the separation between the business and its owners, potentially leading to veil piercing.
- Failure to Follow Corporate Formalities: Neglecting to maintain proper records, hold meetings, or follow other corporate formalities can undermine the legitimacy of the business entity in the eyes of the court.
Avoiding Personal Liability: Best Practices
To safeguard your personal assets and avoid the risk of piercing the veil, consider implementing the following best practices:
- Maintain Proper Corporate Formalities: Adhere to the legal requirements of your business structure, such as holding regular meetings, maintaining accurate financial records, and documenting important business decisions.
- Separate Finances: Keep your personal and business finances separate by maintaining dedicated bank accounts and avoiding commingling of funds.
- Adequate Capitalization: Ensure your business has sufficient initial capital and ongoing funds to cover its operational expenses and financial obligations.
- Transparent Transactions: Conduct business transactions at arm’s length and ensure that contracts and agreements are properly documented and fair to all parties involved.
- Avoid Fraudulent Activities: Conduct your business with integrity, transparency, and honesty, and avoid any actions that could be construed as fraudulent or deceptive.
- Obtain Professional Guidance: Seek the advice of legal, financial, and accounting professionals to ensure that you are complying with all legal requirements and best practices for your business structure.
- Insurance Coverage: Carry appropriate business liability insurance to provide an additional layer of protection against unexpected liabilities.
Piercing the veil is a legal doctrine that serves as a reminder of the importance of maintaining the integrity of your business entity. By following proper corporate practices, maintaining separation between personal and business affairs, and conducting business ethically, you can minimize the risk of personal liability and protect your financial well-being as a business owner. Remember, prevention is key, and a proactive approach to compliance and transparency will go a long way in safeguarding both your business and personal interests.
What is Piercing the Corporate Veil? How Can You Avoid Personal Liability for Your Business?
Piercing the veil, sometimes called piercing the corporate veil, or piercing the limited liability shield, is a doctrine that has allowed courts to hold business owners personally liable for the debts or liabilities of the company.
Now, generally speaking, if you own a company, you have limited liability. You are not responsible for the debts or liabilities of the company. What you have put at risk is any money you have invested in it, but you don’t have liability beyond that. Now, some states like Texas, for example, will simply say, “Look, if you are involved in some sort of fraud as part of the company, because of your involvement, you are personally liable.” We don’t necessarily need to hold that the veil is pierced. Rather, we are holding you personally liable for what you did in the company. But piercing the veil doesn’t necessarily require your involvement, but it does require your benefit as a shareholder.
Let’s talk about it in detail. The general rule is you are not personally liable for debts of an LLC or corporation. If you have a sole proprietorship, if you have a partnership, you are personally liable. But there are some times when a court looks at the law; the court may say the wrong outcome would result if we enforced the law here. And that gives rise to the court of equity. The court of equity existed before the United States was founded. In the UK, there is a court of law and a court of equity, and if a person can’t get justice in a court of law, they could go appeal to the court of equity, and the court of equity could provide justice and a different resolution than the judges in the court of law could. So the court of equity has always been a way to provide justice when the law wouldn’t produce a just result. Laws are general; they are not specific. And so they don’t always take into account the unique circumstances. And that is why in the United States, our court system incorporates both the court of law and the court of equity. Why is this important? Because related to the court of equity is the doctrine of piercing the veil or piercing the corporate veil. It applies equally to corporations and LLCs. So you could call it piercing the LLC veil. You could call it piercing the LLC shield (limited liability shield). It goes by different names, but piercing the veil is the general concept.
The Equitable Nature of Piercing the Veil
Piercing the veil is an equitable remedy. It is not an independent basis for liability. So first, you have to show that there is a liability. In other words, a corporation owes money for a debt. Once you show that (and it could be an LLC), once you show that, piercing the veil can apply to allow the personal shareholder or owner of the company to be liable for the corporation’s debts. So it is a remedy. It is a way to solve a debt that has already been established. It is not an independent basis for why a corporation could be liable.
Key Elements for Piercing the Veil
1. Requirement of Inequitable or Unjust Results
First off, as a foundational matter, a court must find that inequitable or unjust results would occur if the court doesn’t pierce the veil. So the court has to find that it would be unjust not to pierce the veil, that basically, somebody has done something wrong, and justice would not be served unless they were held liable. That is why for somebody to be liable for piercing the veil usually means they have done something wrong, and typically, they did it intentionally wrong. So that would be fraud versus unintentional, like negligent misrepresentation. So the first requirement is that there be a need for piercing the veil. Otherwise, injustice would result.
2. Improper Conduct and Wrongful Acts
There needs to be some sort of improper conduct: that might be fraud, misrepresentation, or wrongful acts. What are some examples of this? Well, let’s say a shareholder who is also the president of the company is signing contracts for the company that the shareholder knows the company cannot honor. That would be an example of a wrongful act. So, for example, let’s say the shareholder or the president, who is also a shareholder, signs a contract with a customer that says, “If you pay us a million dollars, we will provide the following services for you for the next year.” So the customer pays a million dollars. That million dollars is then paid out as a profit distribution to the shareholder. And then, after three months, the company doesn’t have the means to continue to serve the customer, and so the company stops serving the customer. If a judge looks at that scenario and says, all right, clearly, the shareholder, who is the president, knew they couldn’t perform for a year. They took the money anyway, and they moved that money to the shareholder. The judge could deem the company’s veil should be pierced. The shareholder should be liable to the customer, and the shareholder must turn over profit distributions to the customer. Why? Because the shareholder did something wrong. The shareholder signed a contract that the shareholder knew could not be fulfilled.
3. Treating Shareholder and Company as Alter Egos
Usually, what this means is there is not a clear delineation between the company and the shareholder.
What are some examples? Well, separate bank accounts are one basic example. The shareholder shouldn’t be using the company’s account for personal purposes and vice versa. The company shouldn’t be using the shareholder’s bank account for business expenses.
A related area is when an employee is working for two separate companies but only being paid by one. Both companies can be liable for the acts of the other if they are not clearly delineating which company the payroll is coming from. So if you have an employee working for two separate companies, they should get two paychecks, and the time worked by that employee should be separated by company, and they should be compensated for that time for each company. Another area where courts have held there is not sufficient separation between companies is where one company owns the real estate and the other company uses the real estate, and they are both owned by the same shareholder. They should have a contract between them, like normal companies would if they are renting office space or a factory. So if you don’t have contracts of some sort between your companies, a judge can hold that they are alter egos of each other.
So when my clients have a holding company and an operating company, I will usually put together a really quick and simple contract between those two companies to check the box that we followed the formality of keeping those companies separate and treating them like separate companies out in the marketplace. I should note that the alter ego is not necessary for piercing the corporate veil, but it is often a factor that is considered. These factors are unique to each state. And so, you need to look at each individual state to see what its Supreme Court has held are the factors for finding a veil should be pierced.
4. Extreme Undercapitalization
For example, if a business was started with virtually no money and no insurance and it engaged in high risk, there have been courts that have said the shareholders didn’t put adequate money into that company. And so they should not be allowed to avoid liabilities caused by that company.
I will give you an example. There was an owner of a taxi company who decided to set up an LLC for each individual taxi cab, and then the owner did not carry a lot of insurance for those taxi cabs. The idea was if one taxi got into an accident, let’s say it hurt people or whatever, although that taxi would be totaled, all the other taxis would be protected from liability (all the other taxis that are owned by this owner.) So, the court then looked at that case and said, “Did the owner put sufficient money or have sufficient insurance in that LLC?” Now, in this particular case, the court said, “Yes, they did,” and so the court would not pierce the corporate veil, but many other jurisdictions, many other states would hold that if a single LLC didn’t have much money, and it was known that cars get into accidents, that it was irresponsible. It was reckless. It was against public policy to allow somebody to start a company with the knowledge that accidents occur and not have at least some reasonable amount of insurance or funds in that company to cover the injuries that statistically will occur in a cab company. So that particular case, although it went in favor of the LLC owner and the veil was not pierced, or maybe it was a corporation, I forget, in many other states, that would be a great example of where the company is undercapitalized. So again, this is a state-by-state issue that is the doctrine of piercing the veil.
It generally applies equally to corporations and LLCs, but because it is so state-specific, you need to look at what the Supreme Court in a particular state held are the elements for piercing the veil in that state.
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I am Aaron Hall, an attorney for business owners and entrepreneurs. If you would like to get more videos like this, feel free to follow this channel by subscribing. And I encourage everybody to subscribe at aaronhall.com/free. That is where you can get some exclusive videos, helping business owners avoid common and expensive legal problems and help grow your company so you achieve success in your company and, hopefully, as well in your life. Thanks for joining me here today.