Corporate formalities are one of the most important aspects in the world of regulated entities.
While corporate officers are liable for their own management, shareholders do not often get dragged into litigation because of liability issues.
This separation is important to shield investors from the litigious matters within a company. However, courts have created ways to get around separating corporate entities, and this is where "piercing the corporate veil" comes into play.
What is the Corporate Veil?
The corporate veil is the separation of a corporation and its shareholders. The courts consider it "sacred" and therefore, courts will not allow parties to pierce this veil, except under certain situations.
Why Does The Corporate Veil Exist?
The corporate veil exists to provide personal liability to LLC owners and investors from being dragged into litigation when things go wrong.
Otherwise, if a shareholder were not protected by the corporate veils, they would not have any personal liability and would be forced to defend themselves in any matter within the company.
In short, it protects third parties that have nothing to do with a party's internal affairs.
What is Piercing the Corporate Veil?
There are two types of veil piercing: "piercing the corporate veil" and "lifting the corporate veil." The difference between these two actions is the severity of the action.
Lifting the corporate veil is a less severe action because it allows for a single shareholder to be brought into litigation if they have committed wrongdoing against an outside party.
In contrast, piercing the corporate veil entirely disregards any distinction between the LLC and its investors, which can lead to a complete disregard in a company's assets.
When Do Courts Pierce the Corporate Veil?
Generally speaking, the courts only allow veil-piercing when a formal business structure has not been used. Meaning that disregarding corporate formalities is usually what allows for this type of action to take place.
Although there are no specific guidelines for what to look for in determining whether the court will pierce or lift the corporate veil, generally, these actions are reserved for 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
- 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 own formalities and disposes of assets in a way that does not benefit all shareholders
Unity of Interest Test
Although there is no specific test, courts will often examine a series of factors in determining whether or not to pierce the corporate veil.
The most commonly used test is called the "unity of interest" test.
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.
Main Situations Where Creditor Can Pierce The Corporate Veil
There are two main situations where creditors can pierce the corporate veil:
- When a company is acting as an alter ego of its management
- 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.
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 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 usage of the LLC's own bank account to pay your personal bills or business debts.
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 was 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 misappropriated funds from the Limited Liability Company, 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 creditors can hold you 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
Courts consider many different factors when it comes to piercing the corporate veil. However, there are several key factors that courts tend to focus on when considering 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 that eliminates or reduces the chance of another member from having a say in a transaction that affects them both.
How Can Piercing the Corporate Veil Harm My Business?
If the corporate veil is pierced, 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.
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 can directly impact any employees, as well as outside parties such as vendors and customers (ex: suppliers). It allows creditors to seize assets otherwise protected by an LLC or corporation.
Why Should Someone Worry about Piercing the Corporate Veil?
In most cases, a shareholder or owner of an LLC or corporation should not worry that the corporate veil will be pierced as long as they are complying with their state's requirements and laws.
Does Corporate Veil Apply to LLC?
Whether the corporate veil applies to an LLC depends on whether the state in which it was formed has adopted a so-called "business judgment rule" for LLCs.
Is Piercing the Corporate Veil Bad?
Yes, the corporate veil is bad because it allows a company's creditors to come after you personally if they have a problem with your business. Piercing can be very dangerous for small business owners and LLCs because it makes all of their assets exposed to potential lawsuits.
Can I Avoid Piercing the Corporate Veil?
You cannot completely avoid piercing the corporate veil by following LLC or corporation formalities.
However, you can avoid it by making sure that neither you nor any other owners are engaging in activity that could be seen as wrongdoing, mismanagement of company assets, or having an unfair advantage over the other members.
What Are the Effects of Piercing the Corporate Veil?
Piercing the corporate veil can have several effects. It allows creditors to come after personal assets without having to go through the company's assets.
It also destroys the protection that the corporate mask offers companies, allowing them to be subject to creditor lawsuits without any regard for their separate identity.
Piercing the Corporate Veil: LLC & Corporation Risks
In conclusion, while there are many different factors involved in piercing the corporate veil, some of the most important include the relationship between shareholders or the business owner of an LLC and the company they own.
Courts also look at whether one shareholder is acting in a way that is not in the best interest of all shareholders.
Whether a shareholder or business owner is using their position within the company to take advantage of another party, or whether one member has significant power that eliminates or reduces the chance of another member from having a say in a transaction that affects them both.