Piercing the Corporate Veil: What It Means and How to Avoid It

When starting a business, one of the primary reasons entrepreneurs choose entities like corporations or limited liability companies (LLCs) is the protection they offer. These entities create a legal “veil” between the business and its owners, shielding personal assets from business liabilities. However, under certain circumstances, courts can pierce this corporate veil, exposing owners to personal liability for business debts or legal claims. This article explains what piercing the corporate veil means, the conditions under which it can happen, and how business owners can avoid this potentially devastating outcome.

What Is Piercing the Corporate Veil?

Piercing the corporate veil occurs when a court disregards the legal separation between a business entity and its owners. Normally, the corporation or LLC is treated as a separate “person” in the eyes of the law, responsible for its own debts and obligations. However, if owners abuse the entity’s structure or fail to respect its formalities, courts may hold them personally liable. This concept is a legal remedy used sparingly to prevent fraud, unfairness, or abuse.

Basically, a court will determine how to treat your business based on the way that you yourself treat your business.

When Can the Corporate Veil Be Pierced?

Again, Courts are generally reluctant to allow veil piercing. Thus, whether it can be applied is highly dependent on the surrounding circumstances. These typically include:

1. Commingling of Personal and Business Assets

If an owner treats the business’s finances as their own—such as using the company bank account to pay personal bills or buying personal assets with company funds —it blurs the line between the business and its owner.

2. Undercapitalization

When a business is set up without enough funds to cover its reasonable expenses and liabilities, it may appear that the owners never intended the entity to function as a legitimate, independent business.

3. Failure to Follow Corporate Formalities

Corporations, and to a lesser extent LLCs, are required to observe certain formalities. For corporations, this includes holding regular board meetings, maintaining accurate records, and filing necessary paperwork. Ignoring these formalities can weaken the perception of the business as a separate entity. For small businesses, it may seem silly to have to adhere to these formalities, but failure to do so can have dire consequences.

4. Fraud or Misrepresentation

If owners use the business entity to commit fraud or mislead creditors, courts are more likely to pierce the veil to ensure accountability. Veil piercing is particular apt in the case of fraud as generally, by the time a party brings forth an action for fraud against the entity, that entity could very well be dissolved or undercapitalized.

5. Improper Purpose or Abuse

Using the business entity to shield illegal activities or avoid legitimate debts can lead to personal liability. Courts are particularly vigilant about preventing entities from being used as vehicles for injustice.

Key Cases That Illustrate Piercing the Corporate Veil

Courts have developed the concept of piercing the corporate veil through various cases, which highlight the situations where this legal doctrine is applied:

• Walkovszky v. Carlton (1966):This case involved a taxi company that undercapitalized its operations, leaving injured parties unable to recover damages. While the court did not pierce the veil in this case, it highlighted the importance of adequate capitalization.
• Kinney Shoe Corp. v. Polan (1991): In this case, the court pierced the corporate veil because the business owner undercapitalized the entity and failed to observe corporate formalities, using the company as an extension of his personal dealings.

These cases demonstrate that courts are more likely to intervene when owners fail to maintain a clear separation between themselves and their business.

Consequences of Piercing the Corporate Veil

By far the most significant consequence of veil piercing is the loss of limited liability protection. Once the veil has been pierced, the owners can be held personally responsible for the business’s debts and other obligations.

How to Avoid Piercing the Corporate Veil

Fortunately, there are steps business owners can take to minimize the risk of having the corporate veil pierced. By following best practices and maintaining a clear distinction between the business and its owners, you can protect your personal assets and the integrity of your business entity.

1. Keep Personal and Business Finances Separate

• Open a dedicated bank account for the business.
• Use the business account exclusively for business expenses, and pay yourself a salary or distributions from the business rather than dipping into its funds directly.
• Avoid using personal funds to cover business expenses unless formally documented as a loan or capital contribution.

2. Adequately Capitalize Your Business

• When starting your business, ensure it has enough capital to cover its operational needs and potential liabilities.
• Avoid relying solely on debt or personal guarantees for funding.

3. Follow Corporate Formalities

• For corporations: Hold regular board meetings, record minutes, and document major decisions.
• For LLCs: While formal meetings may not be required, create an operating agreement and keep it updated.
• File annual reports and renew licenses or permits as required by your state.

4. Maintain Accurate Records

• Keep detailed financial and operational records for the business.
• Document all transactions between the business and its owners, including loans, leases, or services.

5. Avoid Fraudulent or Unethical Practices

• Operate the business in good faith and avoid engaging in fraudulent or deceptive activities.
• Be transparent with creditors, employees, and stakeholders about the business’s financial status and obligations.

6. Use Contracts and Agreements

• Use written agreements for business transactions, even with friends or family.
• Clearly define roles and responsibilities within the business to avoid misunderstandings.

7. Purchase Appropriate Insurance

• Consider liability insurance to protect against potential claims that could exceed the business’s assets.
• For high-risk industries, ensure sufficient coverage to address industry-specific risks.

8. Seek Professional Advice

• Consult with legal and financial professionals to ensure compliance with regulations and best practices.
• Periodically review your business structure and operations to identify potential risks.

Piercing the corporate veil is a rare but serious legal action that can expose business owners to personal liability. Understanding the concept and the circumstances under which courts may apply it is critical for protecting your assets and ensuring the long-term success of your business.

By keeping personal and business activities separate, maintaining proper records, observing formalities, and operating your business ethically, you can significantly reduce the risk of facing this legal issue. While forming an LLC or corporation offers substantial protection, it’s essential to respect the responsibilities that come with it.

If you have concerns about your business practices or entity structure, consulting a qualified attorney can provide valuable insights tailored to your situation. In business, an ounce of prevention is worth a pound of cure—and taking the necessary steps to avoid piercing the corporate veil is one of the smartest moves you can make.