Piercing the corporate veil can expose you to personal liability, but it can be avoided by making a few wise decisions. Piercing the corporate veil occurs when a court decides that the owners, creditors, or directors of a corporation or LLC should be held personally liable for the debts of the corporation or LLC. Many people who have decided to incorporate or form an LLC do so specifically to avoid this personal liability, but it may do no good if the corporation or LLC is not operated appropriately.
The main reason that courts decide to pierce the corporate veil is that the corporation failed to be its own individual entity. Corporations and LLCs must exist separately from their owners because in the eyes of the law such business structures are individual (non-natural) persons. When a court determines to pierce the corporate veil, it is likely because the owners of the corporation, LLC or other structure involving limited liability, failed to adequately separate the business as its own entity. Here are 4 tips to ensure a corporation or LLC is its own entity rather than merely the instrumentality of its owners:
Never Commingle Assets
Assets held by the corporation or LLC must be used by and for the corporation and not for the personal uses of the owners. Owners of a corporation or LLC should never use corporate funds or assets as their own. For example, using corporate funds to pay a personal mortgage or other expense will indicate to the courts that the corporation or LLC is not being operated as a separate entity. Make sure to keep corporate funds and assets separate from personal accounts by maintaining accounts held in the business’s name and recording the expenses for which the corporate funds and assets are used.
Make Sure Your Corporation is Adequately Capitalized
Part of ensuring that a corporation or LLC operates as a separate entity is that it actually has enough capital to maintain its operations. Intentional undercapitalization has been used to avoid the debts of the business. If the business does not have adequate capital it cannot pay its debts and liabilities, yet the owners will still remain free from personal liability for those business debts. In such a situation the court may decide to pierce the corporate veil because the owners have essentially defrauded the creditors and/or claimants against the business. To avoid giving the appearance of intentional undercapitalization be sure to keep detailed records of expenses, disbursements, and liabilities of the company. It is also important to establish and maintain usual patterns by which the company is capitalized and gives disbursements. Further, to ensure that the corporation is never undercapitalized, establish a minimum capitalization level. This will show that the corporation plans to payback its creditors and will ensure it has enough capital to continue usual operation.
Corporate Formalities
Corporations or LLCs that do not follow corporate formalities may appear to be sham entities used by their owners as instrumentalities for personal gain. Use of corporate formalities will show that the business is legitimate and being operated as a separate entity. Holding regular meetings of members, shareholders, or directors, keeping detailed records of meetings and business decisions, and adopting bylaws or operating agreements are all important formalities to strictly adhere to as a required formality. Corporations and LLCs that adhere to these practices not only present a legitimate business to the world and to the courts, but also show that the entity is separate from its owners and is not being operated fraudulently.
Holding out the Business . . . as a Business Entity
Finally, an important step in ensuring that the corporation or LLC is actually its own entity is presenting the corporation or LLC as an actual corporation or LLC. Seems simple, right? Making sure the corporate status of the corporation is known is important to ensuring the corporation is dealt with as a separate entity. Business cards in the corporation’s name, a corporate logo, and the corporation’s name on communications are great ways to present the corporation to the world as a corporation. Further, owners of the corporation or LLC should sign business documents by clearly stating their representative capacity within the business next to their signature.
Corporations and LLCs that abide by these simple guidelines are dramatically less likely to deal with issues of piercing the corporate veil, and their owners are more likely to sleep much easier. Keeping your corporation or LLC as a separate entity is the best way to avoid piercing of the corporate veil. By keeping assets and funds separate from personal accounts, adequately and regularly capitalizing the business, following corporate formalities, and clearly presenting the business as a separate entity will help protect you as a business owner and maintain the veil of protection.