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Piercing the Corporate Veil

When small business owners discuss business structure with a corporate law attorney, they sometimes ask what might happen if they get sued. A business attorney can explain all the differences between a sole proprietorship and a limited liability company (LLC) or corporate entity. One of the most critical distinctions is the protection of the owner's assets in a legal action.

What Is the 'Corporate Veil'?

Owners are personally liable for the company's debts in a sole proprietorship or partnership. The business is not a separate entity from its owners. A plaintiff can seize the owner's personal assets to pay a judgment against the business.

In an LLC or corporation, the business entity protects the personal liability of the owners, officers, and shareholders. The company owns the business assets, not the owners or board of directors. This "corporate veil" protects the owners' assets in case of legal action.

Piercing the Corporate Veil

When individuals use the corporate veil to conceal acts of wrongdoing, courts will order the limited liability protection lifted. "Piercing the corporate veil" allows a judgment to reach the personal assets of the owners and officers.

Piercing the corporate veil is rarely done in courts. The courts will not lift the veil merely because a business cannot pay a judgment. Corporate assets must pay for corporate debts unless the court finds good reason to remove the veil and take the individual owner's property. Two elements must exist to pierce the veil.

  • Unity of Interest: The interests of the company and the owners or officers are indistinguishable. This is sometimes called "alter ego." Another way to meet this element is for an officer or owner to commit fraud or financial crime to benefit the company.
  • Inequitable Result: There must be an unfair outcome if the acts stand as those of the business entity and not those of the individuals.

No specific laws or statutes allow a court to pierce the corporate veil. A judge decides each case on its unique facts. State courts have their own elements that a plaintiff must prove to establish unity of interest or "alter ego."

Common Reasons Courts Allow Piercing of the Corporate Veil

One of the earliest cases, Minifie v. Rowley, 87 Cal. 481 (1921), established the doctrine of alter ego and has been case law since. These are some common reasons courts will set aside limited liability protections and satisfy a judgment from an owner's personal funds.

Criminal Acts

Fraud, theft, insider trading, or other overt criminal activities by the owners or officers meets the unity of interest element. Committing a crime to benefit the company, whether done with the knowledge of others in the corporation or not, is outside the operating agreement of any legitimate business.

Courts only withdraw the corporate veil from the wrongdoer when criminal acts occur. The veil protects uninvolved agents and corporate shareholders.

Commingling Assets

You may have heard media reports of corrupt business owners using a business as their "personal piggy bank." Commingling assets occurs when an owner or manager uses a business bank account to pay their own bills or uses a business credit card for personal expenses.

LLCs and professional limited liability companies (PLLCs) often run afoul of this. Doctors, attorneys, and other sole practitioners may incorporate themselves for professional liability reasons. Then, they may use the business account as a personal account without considering the possible dangers. Your LLC can avoid this by paying you a salary or taking a draw against owner dividends.

Failing To Keep Related Businesses at Arm's Length

A related error is entanglement with related businesses. A "wholly-owned subsidiary" is a separate company. It should have separate bank accounts, offices, and registered agents from the parent company. If a wholly-owned subsidiary has too many corporate identifiers in common with the parent, it appears that the subsidiary is an alter ego of the parent or an officer of the company. This would warrant lifting the corporate veil.

If the parent uses the subsidiary to "hide" money during litigation, commingling the parent company's assets or concealing them completely would be embezzlement or fraud.

Undercapitalization

"Capitalization" means a business has enough funds to operate when it files its articles of incorporation. Adequate capitalization depends on the nature of the business and state law. A lack of capitalization is not enough to raise the veil.

However, if the corporate shareholders knew from the beginning that the company lacked funds to pay business debts, this would justify piercing the veil. Undercapitalizing a subsidiary or franchise would also be enough.

Lack of Corporate Formalities

Even small companies must follow the rules. Becoming a corporation or LLC means obeying corporate forms. This includes filing an annual report, keeping corporate records, maintaining by-laws, and all the minutiae that make a corporation a legal entity.

Small businesses and one-person LLCs may not always follow corporate formalities. However, they are still subject to corporate liabilities. Lack of an annual report will not cause a judge to lift the corporate veil, but it is one element in the case against you.

Need To Know More About Piercing the Corporate Veil?

If you have questions regarding piercing the corporate veil to hold owners or managers liable for the actions of their corporation, contact a local business attorney who can help you explore your options. A business and commercial attorney can help you safely set up and run a corporation.

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