What Does Piercing the Corporate Veil Mean for an LLC?

Corporate formalities are a big aspect of the world of regulated entities.

While corporate executives are responsible for their administration, shareholders rarely involve themselves in legal disputes due to liability concerns and costly internal business issues.

However, if legal entities decide to "pierce the corporate veil," they can make shareholders liable for certain disputes.

So, what does piercing the corporate veil mean in terms of an LLC?

As someone with extensive knowledge in business formation and a test-and-learn approach, I've gathered all the relevant information to help you understand this term better.

Quick Summary

• Piercing the corporate veil refers to a situation in which a court disregards the separate legal entity status of a limited liability company (LLC) and holds the owners or members personally liable for the business debts, liabilities, or wrongful acts within the business.
• There are two ways to pierce the corporate veil — piercing and lifting; the one used depends on how severe a problem is.
• According to the American Bar Association (ABA), over 30% of small business owners surveyed lacked a clear understanding of limited liability protection.
• I always remind my clients of the importance of the corporate veil. If the corporate veil is lifted, all of an LLC's or corporation's assets are made available to creditors.

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What Does Piercing the Corporate Veil Mean?

Before I get into what piercing the corporate means, let's first understand what's meant by a corporate veil.

What Is the Corporate Veil?

The corporate veil is the separation of a corporation and its shareholders. The courts consider it "sacred," and therefore, they will not allow parties to pierce this veil, except in certain situations.

In essence, the corporate veil is a legal concept that effectively separates a company's assets and liabilities from those of its owners, providing them protection from personal liability for the company's debts and actions.

According to the American Bar Association (ABA), over 30% of small business owners surveyed lacked a clear understanding of limited liability protection. This suggests that a potential knowledge gap regarding proper LLC formation and operation could increase the risk of veil piercing.

What Does the Term "Piercing the Corporate Veil" Refer To?

The term "piercing the corporate veil" refers to the legal strategies courts have developed to avoid dissolving corporate entities.

Piercing the corporate veil involves two legal actions: "lifting" and "piercing" the veil.

Lifting, which involves holding a single shareholder accountable for misconduct within an LLC's structure, is less severe.

Piercing is more severe. It disregards the LLC's separation from investors, potentially jeopardizing business assets [1].

While it happens in many cases, a 2009 study from the University of Minnesota Law School found that courts seldom pierce the subsidiary's corporate veil [2].

"Treat your LLC as a separate legal entity. Don't use company funds for personal expenses, and avoid making personal guarantees on business debts. These actions can weaken the veil of limited liability."

- Delina Yasmeh, J.D./Tax LL.M, Distinguished Expert in Mergers & Acquisitions

Why Does The Corporate Veil Exist?

The corporate veil exists to prevent LLC owners and investors from being dragged into litigation for the actions of one or more shareholders' actions. Without the corporate veil, a shareholder would not have any personal accountability and would be required to represent oneself in any internal dispute.

In short, the corporate veil protects third parties that have nothing to do with a party's internal affairs, preventing them from becoming held personally liable.

How Can Piercing the Corporate Veil Harm My Business?

Piercing the corporate veil can harm your business reputation and lead to loss of limited liability protection. In my experience as an entrepreneur, I witnessed several LLCs go down when the corporate veil was pierced.

When this happens, all of an LLC's or corporation's assets are exposed to creditors.

This means that lawsuits against the company will be able to literally "pierce" through the walls of the limited liability company and come after your personal assets [3].

Moreover, this type of action can lead to a complete disregard for the company's assets and efforts because courts will not look at the company as a separate legal entity.

This action can directly impact any employees, as well as outside parties such as vendors and customers (e.g., suppliers). It allows creditors to seize business assets otherwise protected by an LLC or corporation.

Based on insights from the American Corporate Counsel Association (ACC), LLC lawsuits alleging veil piercing based on commingling of personal and business funds have increased by nearly 15% compared to the previous year.

When Do Courts Pierce the Corporate Veil?

Courts pierce the corporate veil when a formal business structure has not been used. In other words, courts take this type of action when corporate procedures are disregarded.

There are no specific guidelines for what to look for in determining whether the court will pierce or lift the corporate veil, but these actions may lead to the following scenarios:

• When an LLC or corporation is controlled by one or two people.
• When the courts are being asked to disregard corporate formalities, which can include disregarding minutes of incorporation meetings, ignoring company bylaws, disregarding shareholder meetings and voting, etc.
• The person asking the court to disregard the corporate formalities is not a majority shareholder or owner.

Examples of Piercing the Corporate Veil

Let's look at some examples of when the corporate veil can be pierced:

• A minority shareholder attempts to look through the veil of personal liability protection and sue another shareholder for liability.
• An LLC member makes personal transactions using company money without approval from other members.
• When an LLC has disregarded its own LLC agreement or bylaws.
• When a shareholder or an owner makes a transaction using the company's property for personal use. This is referred to as fraud on the minority.
• An LLC going through bankruptcy due to business debts disregards its formalities and disposes of assets in a way that does not benefit all shareholders.

Unity of Interest Test

Reflecting on my journey when I first began helping startups, I learned the critical importance of the unity of interest test.

The unity of interest test is used by courts to determine whether or not to pierce the corporate veil.

In this test, courts evaluate the extent of personal liability. In other words: how separate a business entity's affairs are from its shareholder's personal affairs and how much overlap exists between the management of the company and its shareholders.

If there is a complete unity of interest, then courts will likely pierce the veil.

If there is an absence of unity of interest, then courts will not pierce the corporate veil.

This analysis does not mean that courts only look at one factor to determine if they should pierce or lift the corporate veil.

It should be noted that even if a court decides not to pierce the veil, they may still disregard other formalities and consider personal assets belonging to one owner as a part of the corporate assets.

Major Situations Where Creditor Can Pierce The Corporate Veil

There are two main situations where creditors can pierce the corporate veil: 

1. When a company is acting as an alter ego of its management
2. When there is fraud or other wrongdoing committed against an outside party

Both of these situations are extremely fact-dependent, which means that each case will be decided on its own merits.

1. When a Company is Acting as an Alter Ego of its Management

The creditor may force you to disclose all of your assets if it can be shown that the LLC did not have a distinct identity.

There are many cases where creditors have pierced the veil because there was no real distinction between an individual's personal bank account and their LLC's bank account.

One reason why courts failed to see a difference is because of insufficient formalities between shareholders and LLCs.

For example, if there is no clear evidence that you are the real party of interest in your LLC, then it will be hard to separate your personal account from the company. Another example is the use of the  LLC's bank account to pay your personal bills or business debts.

2. Fraud or Wrongful Actions

Creditors can pierce the veil and hold you personally liable if there is evidence that you used your status as a shareholder for fraudulent or wrongful acts.

A creditor can also lift the corporate veil and bring shareholders into litigation if there is misconduct with limited liability company assets, such as the commingling of funds between an individual and his/her limited liability company.

For example, if a majority shareholder misappropriates funds from the limited liability company for personal expenses, a creditor would have a court order that authorizes it to collect against shareholders.

In another example, if you used your position as a shareholder to carry out wrongful acts that harmed an individual or entity, then you can be held personally liable for those actions.

In short, creditors can lift the corporate veil if there is evidence of wrongdoing.

Factors Courts Consider in Piercing the Corporate Veil

Based on my experience, I've noticed that courts tend to focus on the following criteria when piercing the corporate veil:

• The relationship between shareholders or owners of a limited liability company and the company they own.
• Whether one shareholder is acting in a way that is not in the best interest of all shareholders.
• Whether a shareholder or owner is using their position within the company to take advantage of another party.
• Whether one limited liability company member has significant power eliminates or reduces the chance of another member from having a say in a transaction that affects them both.

Incorporating Compliance into Your Business Strategy

Integrate regulatory compliance as a core component of your business operations.

Consider consulting with legal and financial experts to ensure that your LLC meets all relevant requirements.

By doing so, you not only safeguard your business against potential legal challenges but also fortify the corporate veil that separates your personal assets from business liabilities.

FAQs

References:

1. https://www.irs.gov/pub/irs-ccdm/cc-2012-002.pdf
2. https://scholarship.law.umn.edu/cgi/viewcontent.cgi?article=1107&context=faculty_articles
3. https://www.munizzilaw.com/blog/when-can-a-member-of-an-llc-be-personally-liable-for-judgments-against-the-llc