What is Piercing the Corporate Veil and How to Avoid It

Piercing the Company Veil - How to Avoid It

50% of piercing the veil court cases nationwide succeed because owners are not following corporate formalities. The risk of personal liability is not limited to corporations; it can apply to all types of business entities and business structures, including LLCs, partnerships and sole proprietorships. This means business owners can lose their stuff. Following the rules and regulations for your business entity is key to avoiding personal liability and maintaining the legal protections of your business structure.

What is the Corporate Veil?

What is the corporate veil? How can it protect me and what does it mean when it’s pierced? We’ll cover these important liability, wealth and asset protection concepts. By forming a corporation, LLC or Limited Partnership (LP) and following the required corporate formalities, a corporate veil is raised that may protect shareholders, officers and directors from personal liability and tax benefits. A corporation is considered a corporate entity, meaning it’s a separate legal entity from its owners, which limits personal liability and protects personal assets. A sole proprietorship doesn’t provide this legal separation or liability protection, as the business and the owner are considered the same legal entity. But to ensure the corporate veil remains intact and the business meets its potential, all persons involved in the corporation must follow certain corporate formalities. (While we refer to corporations in this article, the concepts and issues apply to LLCs and LPs as well. Don’t be misled by those who say the need for following formalities only applies to corporations)

If you don’t follow the requirements of corporate formalities, you could be subject to court decisions that pierce the corporate veil. Today 50% of piercing the veil court cases succeed because owners are not following corporate formalities. For example, if an owner uses company funds for personal expenses and doesn’t maintain the separation between the corporate entity and personal affairs, a court may pierce the corporate veil and hold the owner personally liable.

Introduction: Why the Corporate Veil Matters

The corporate veil is a fundamental concept of business law that provides a layer of protection for business owners. By forming a company as a separate entity, the corporate veil shields owners from being personally liable for business debts and liabilities. This means your personal assets—your home, car or savings—are generally safe if your business runs into financial trouble or legal claims. But this protection is not automatic or guaranteed. If the corporate veil is pierced, owners can find themselves personally responsible for the company’s obligations, putting their personal assets at risk. That’s why understanding the corporate veil, following corporate formalities and maintaining a clear separation between personal and business affairs is crucial for any business owner who wants to avoid personal liability and protect their wealth. By treating your business as a separate legal entity and respecting the boundaries set by law, you can ensure your personal assets are protected from business debts and liabilities.

Separate Entity

Creating and maintaining a separate entity is the foundation of protecting the corporate veil. Business owners must take deliberate steps to show that their company is a separate legal entity, not just an extension of their personal finances. This starts with opening a dedicated business checking account and ensuring all business transactions flow through it, never mixing personal and business funds. Accurate and up-to-date corporate records are key—this means keeping minutes of meetings, documenting major decisions and maintaining all required filings. Regular board meetings, even for small or closely held companies, demonstrate the business is operating independently and following corporate formalities. And make sure the company has enough capital to meet its obligations, undercapitalization can be a red flag for courts considering whether to pierce the corporate veil. By following these practices consistently, business owners reinforce the company’s status as a separate entity, preserving limited liability and reducing the risk of being held personally liable for business debts.

Limited Liability

Limited liability is one of the greatest benefits of forming a corporation or limited liability company (LLC). It means as a business owner your personal assets are generally protected from the company’s debts and legal obligations. But this protection is not absolute. If you don’t follow corporate formalities, mix personal and business funds or engage in serious misconduct a court may pierce the corporate veil—making you personally liable for business debts. To avoid this risk you must maintain a separate entity by keeping thorough records, holding regular meetings and ensuring your company is adequately capitalized. Understanding the limits of limited liability and the corporate veil empowers you to take the right steps to protect your personal assets. By following the rules and treating your business as a separate legal entity you can avoid personal liability and keep your personal wealth safe from business risks.

Piercing the Corporate Veil

A situation in which courts ignore limited liability and hold a corporation’s shareholders or directors personally liable for the corporation’s actions or debts. Courts will pierce the corporate veil when the corporation is found to be the alter ego of its owners. Veil piercing is most common in close corporations. While the law varies by state, generally courts have a strong presumption against piercing the corporate veil and will only do so if there has been misconduct like abuse of the corporate form (e.g. intermingling of personal and corporate assets) or undercapitalization at the time of incorporation. Courts consider several factors when deciding whether to pierce the veil, such as commingling of assets, undercapitalization and lack of corporate formalities. (Undercapitalization would apply if the corporation never had enough funds to operate and was not really a separate entity that could stand on its own). Fraud or wrongful conduct by owners can also justify piercing the corporate veil.

If corporate formalities such as annual corporate filings and meeting minutes are not maintained in a timely and proper manner, courts can hold YOU, the entity’s owner, personally responsible for claims filed against the company. If these conditions are met, owners can be held responsible for the company’s debts, especially in cases involving fraud or wrongful conduct. You need to keep your corporation filings current and your legal protections intact.

How to Avoid Piercing the Corporate Veil

Limited liability and tax benefits are not a right granted to every business person but privileges earned by following corporate formalities. The following nine rules provide general guidance for maintaining the corporate veil while conducting business through a corporation:

• File all annual filings;
• Maintain internal formalities, including having a resident agent in their state of formation and in any state the company qualifies to do business in;
• Maintain a written record of corporate decisions;
• Provide the world with corporate notice;
• Ensure the corporation is sufficiently capitalized;
• Maintain the distinction between corporate assets and personal assets;
• Use caution when distributing corporate profits;
• Separate bank accounts;
• Separate tax returns; and
• For LLCs, maintain a written operating agreement

While the burden of maintaining corporate formalities may not be appealing the consequences of neglecting corporate formalities are great. Managers and LLC members must also ensure compliance with these rules. Whether the corporation has followed the foregoing rules becomes important when a creditor seeks to receive payment through the assets of the corporation’s individual shareholder, director, officer or manager. Managers can be held personally liable if they fail to maintain corporate formalities and LLC members may also face personal liability if the LLC’s limited liability is pierced due to misuse or undercapitalization. Each rule and its various implications are discussed more in depth below.

If you are unsure if you are in compliance or would like to hire Corporate Direct to ensure that you are we offer a corporate cleanup service to assist.

How to Raise the Corporate Veil

Once you have decided that a corporation, LLC or Limited Partnership (LP) is the right entity for your business or asset holding purpose and you have decided which state to incorporate in corporate formalities begin. Events occurring immediately after formation must be performed properly to maintain the corporate veil and ensure the corporation’s longevity and flexibility.

A corporation is born when the Articles of Incorporation are properly filed. The corporate veil provides Shareholders with limited liability and is raised and maintained by management and ownership that treats the corporation like a corporation. As indicated above a corporation is considered to be a legally distinct entity, capable of incurring its own debts and obligations. This protection is frequently referred to as the corporate veil. When creditors or others seek to obtain a judgement from a court that makes the corporation’s shareholders, directors or officers personally liable they are seeking to pierce the corporate veil. This article will focus mostly on maintaining the corporate veil once it has been established but briefly here are the requirements needed to set it up:* File the Articles of Incorporation

• Hold organizational meetings to empower the corporation to conduct business and provide limited liability.
• Provide the corporation with competent initial management
• Issue the corporation’s shares of stock

Once these steps are completed the corporation can take out a business loan in its own name. This means that if the business loan is defaulted on only the corporation’s assets are at risk not the personal assets of the owners.

Maintaining the Veil by Maintaining Corporate Formalities

Filing Annual Reports

Annual reports are required to protect and ensure the longevity of the corporation. In addition to the permits, licenses or approvals that are unique to the corporation’s business every corporation must obtain and maintain a corporate charter in good standing. In many states a corporation must file an annual report providing the names and addresses of Officers and Directors and annual fees. If such filings are not completed in a timely fashion the state may revoke the corporate charter and the corporation will cease to exist. The time, energy and expense expended organizing the corporation will be wasted if the state revokes the corporate charter. While it may be possible to have the charter reinstated the best way to maintain the corporate veil and ensure the corporation serves its purpose is to simply file annual reports on time.

Internal Formalities

Bylaws adopted by the Directors in their organizational meeting provide the guidelines for the corporation’s future actions and corporate policy. Specifically the Bylaws should provide:

1. Notice requirements for Directors meetings; 2. The minimum number of annual Directors meetings; 3. The date for annual Shareholders meetings; 4. The requirements for special Shareholders meetings; 5. The responsibilities of each Officer and Director; 6. The procedures for removing Officers or Directors; 7. The procedures for Shareholders’ inspection of the corporation’s records; and 8. The name and address of the corporation’s resident agent.

Although they shape the internal operations of the corporation Bylaws should not be complicated or provide intricate procedures. Necessity determines the extent and detail provided in the corporation’s Bylaws which may be amended, altered or repealed by the Board of Directors.All decisions the corporation makes and all actions the corporation takes should be in accordance with the rules established by the Bylaws. Compliance with the Bylaws means the corporation’s Directors, Officers and Shareholders are treating the corporation as a separate entity with its own rights and limitations. If the Directors, Officers and Shareholders treat the corporation as a separate entity courts will be less likely to ignore the division between corporate property and the rights of the individual Directors, Officers and Shareholders. The corporate veil will be maintained.

As well in most states it is required to have a current resident agent to accept service of process. Failure to have a resident agent in place can lead to arguments that the corporate veil should be pierced.

Maintain a Written Record of Corporate Decisions

Even if a small group of people or a single person controls the corporation it should hold meetings and prepare records of such meetings. Shareholders and Directors hold three types of meetings which should each be recorded through minutes of meetings. As provided above immediately following incorporation organizational meetings should be held. During the corporation’s life regular meetings must be held annually pursuant to the corporation’s Bylaws to reflect elections and the corporation’s other decisions. Special meetings may be held when called by the Directors or Shareholders. Special meetings are held to discuss urgent items of business or to approve any legal or tax issues. The general procedure for holding Directors or Shareholders meetings is below.

Before a Shareholders meeting all Shareholders must receive or waive notice of the meeting. Before a Directors meeting all Directors must receive or waive notice of the meeting. In meetings of Shareholders or Directors corporate formalities require voting and an official record of actions taken at the meeting. The official record of actions taken in regular meetings as well as the organizational meetings is provided as the minutes of the meeting. Minutes provide a record of the corporation’s resolutions. A resolution is a document that records actions that the Directors or Shareholders “resolve” to take on the corporation’s behalf. The nature and timing of the corporation’s decisions determine whether a resolution or minutes of a meeting provide an appropriate record of a decision.An alternative in most states to holding actual meetings and preparing minutes for those meetings is for the corporation to take action by written consent. This is the quickest and easiest way to document formal corporate action. Directors and/or Shareholders sign a document that contains the language of the corporation’s decision or resolution. By signing the document the Directors and/or Shareholders approve the decision or resolution. To ensure an action by written consent is properly documented all Directors and/or Shareholders must sign the consent form. The corporation should keep signed consent forms in the corporate minute book.

By holding the necessary meetings and preparing adequate records a corporation provides documentation to protect the corporate veil. Should a creditor attempt to pierce the corporate veil at a later date the corporation’s records will be evidence of its separate existence. As well maintaining proper records may help to avoid future miscommunications and misunderstandings within the corporation.

Many people believe preparing annual meeting minutes is difficult but the minor inconvenience is far outweighed by the problems that not preparing such records could cause. If necessary a service provider may prepare the required minutes for the corporation for a reasonable fee. Our firm charges $150 per year to prepare minutes. You can call toll-free 1-800-700-1430 for more information.

Provide the World with Corporate Notice

Whenever the corporation enters into a contract or engages in any business activity whatsoever it must do so clearly as a corporation. Individual Officers or Directors may be personally liable if they act on behalf of the corporation but fail to clearly indicate they are acting in their capacity as the corporation’s Officer or Director. To avoid creditors or others from piercing the corporate veil and attacking individual members of the corporation’s management or Shareholders the corporation must be clear that the corporation and not an individual is acting. Business cards, letterhead, invoices, company checks, brochures, etc. must identify the corporation. The full name of the corporation should be provided (not XYZ but XYZ, Inc.). All contracts and correspondences signed by Directors or Officers for the corporation should be signed with reference to their corporate designation. If the corporation takes steps to ensure others know the corporation and not an individual Officer or Director is acting the corporate veil will be more resistant to attack.

Avoid Under-CapitalizationAlthough most jurisdictions will not allow creditors to pierce the corporate veil solely because the corporation had insufficient assets the risk of veil piercing provides reason to ensure the corporation is sufficiently capitalized. California and a few other states have relied on undercapitalization in piercing corporate veils. A corporation should have sufficient resources to meet its short-term obligations whether it is just starting, is part of a cooperative project or is merely one element in a greater corporate strategy. If the corporation is undercapitalized a creditor may argue and a court could accept the argument that the corporation exists simply to help its owners shelter their assets. As is discussed below this may be enough reason for a court to pierce the corporate veil and find personal liability for Officers, Directors and/or Shareholders.

Keep Corporate and Personal Assets Separate

A common but fatal mistake for developing corporations is when its management and/or Shareholders fail to keep corporate and personal assets separate. Using personal funds for business expenses or using the LLC’s funds for personal purposes can undermine the separation between the business and the owner. This is especially true in small or closely held businesses where the risk of mixing personal funds and LLC’s funds is higher. A sole owner is at particular risk of veil piercing if they do not keep this separation. Whether from loans from the corporation to individuals, shared bank accounts, shared tax returns or individual use of corporation property failure to separate corporate assets from personal assets negates the corporation’s separate identity. To prevent creditors from piercing the corporate veil the corporation must keep a separate bank account, file separate tax returns and use corporate assets only for corporate purposes.

The corporation should not be used as a lender to its Officers, Directors or Shareholders. An air of impropriety is created when a corporation loans money to members of management even if management genuinely intends to repay the loan. The recent corporate scandals in spring and summer 2002 highlighted the dangers involved in lending to management as such loans were often cited in allegations that a Director or Officer breached their fiduciary duties. The best way for the corporation to avoid potential problems is to refuse to lend money to its Directors and Officers.Regardless of their personal interest or role in the corporation nobody should treat the corporation’s property as personal property. By keeping corporate and personal assets separate the corporation will indicate and retain its separate identity. By reporting and maintaining corporate assets separately from management’s or Shareholders’ personal assets the corporation will reduce the potential for lawsuits against Officers, Directors and individual Shareholders.

Be Cautious with Corporate Profits

Whether the corporation distributes its profits through dividends to shareholders or compensation to employees the corporation’s distribution of profits can be a basis for creditors to pierce the corporate veil. The veil that limits the liability of Shareholders, Directors and Officers also limits the corporation’s ability to pay such corporate actors from the corporation’s profits. If the corporation fails to follow established rules for the distribution of corporate profits a creditor may use such failure as an indication that the corporate actors are not treating the corporation as a separate legal entity. To reduce creditors’ ability to pierce the corporate veil the corporation must be cautious in distributing its profits.

Every state allows a corporation’s Board of Directors to issue dividends to its Shareholders. However the Directors’ decision to declare dividends may result in substantial fines against the individual Directors if the dividend is found to be illegal. Dividends from surplus cannot exceed limits established by reference to the corporation’s assets. “Nimble” dividends or dividends paid from profits may be issued when the corporation’s surplus is insufficient. However such dividends may only be paid when such payment does not impair the capital representing preferred stock. Directors must determine if the corporation has sufficient funds legally available to pay dividends to protect themselves from potential liability. To avoid liability from issuing dividends corporations should consult with legal counsel before deciding to issue dividends.

Keep a Separate Bank Account

A corporate veil will be pierced in cases where the company founders use a personal bank account for business affairs. You cannot consistently pay business expenses from a personal account and conversely you cannot pay personal expenses from a company bank account. Failure to follow these simple guidelines can be catastrophic so as soon as you incorporate get an EIN (Employer Identification Number) from the IRS and use it to open a corporate bank account.

File a Separate Tax Return

Because you have an EIN for your entity you must now file a separate tax return with the IRS. Don’t worry this is your chance to take all the deductions you are entitled to. But failure to file a separate return can lead to claims that you are not following corporate formalities and in some cases courts may hold shareholders personally liable for business debts if proper procedures are not followed. So file - and take advantage of the tax benefits you are entitled to in the first place.

Many developing corporations don’t have sufficient assets or profits to distribute dividends to Shareholders but they must compensate Officers, Directors or other employees for their services. Especially in start-up businesses the compensation a corporation pays to Officers, Directors and other employees may determine the corporation’s success. Equity compensation (using shares of the corporation’s stock, stock options or other alternative forms of compensation) may be attractive. Compensation based in part on the corporation’s profits may also be appealing. However all forms of compensation should be based primarily on the market value of the employee’s services. The Internal Revenue Service may scrutinize excessive compensation paid to Directors, Officers or employees and tax excessive compensation as dividends.

Corporations that over-compensate their employees may create liability for the Directors based on Shareholders’ claims of mismanagement, breach of fiduciary duties, self-dealing or waste of corporate assets. Through a derivative action the Shareholders may regain control of the corporation and its assets. The corporation may then assert legal claims against former Directors creating personal liability for such Directors. To avoid potential liability based on employee compensation and excessive tax liability Directors must ensure that compensation paid by the corporation is reasonable.

All decisions regarding the distribution of a corporation’s profits or compensation for employees are at the discretion of the Board of Directors. However to avoid potential liability for the corporation and for themselves Directors must carefully consider the effects of every use of the corporation’s assets. Caution and the advice of legal counsel may be necessary to prevent the Board’s distribution decisions from creating unwanted liability.

State Variations

Some states are more likely to pierce the corporate veil than others. The likelihood of having the corporate veil pierced varies by state depending on how courts apply the doctrine of corporate veil piercing. As well in some states veil piercing cases are brought more often. The top five states in order of most cases filed are:

1. New York,
2. California,
3. Texas,
4. Ohio and5. Pennsylvania.

As expected the numbers reflect population. But they also reflect the states where the strategy works.

Nationally 50% of veil piercing cases were successful so be careful with corporate formalities. Frequency of veil piercing cases is important to business owners.

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