Corporate Veil Piercing: How To Avoid It
Protecting Your Assets
If you are a business owner, one of the most significant reasons to incorporate or form a limited liability company (LLC) is to protect your personal assets from a business creditor's claims against your company. This ability of a properly-formed and maintained company to shield its owners from personal liability is sometimes referred to as the "corporate veil". Under certain circumstances, however, business creditors may be able to successfully make a claim against a business owner's personal assets or "pierce the corporate veil". What is Limited Liability and why it is important?
When properly managed, corporate veil provides crucial personal liability protection against creditors, lawsuits, and other disputes. Typically, these claims can only be applied to business assets. An owner's personal liability is restricted to your investment in the company. Personal assets, such as real estate, bank accounts or other investments, are safeguarded from business creditors. In other words, you only risk what you put into the business.
Most veil piercing circumstances occur because a business owner has either failed to abide by the legal requirements for operating a business or because the owner did not clearly separate his personal and business assets. Here are some guidelines for establishing your business and conducting it in a way that makes "piercing the corporate veil" less likely:
Separating Personal and Business Assets
If you are the owner of a corporation or an LLC, you are obligated to maintain a legal separation between yourself and your company. If you fail to do this, you risk creditors claiming that your company is merely your "alter ego" - a mere shell of your "self". Your personal assets may then become vulnerable to business creditors. These are some of the steps to take in order to separate business and personal assets:
First, not only should you maintain separate bank accounts for your business and personal finances, but you should never use company funds to pay your own personal expenses. If it becomes absolutely necessary for you to provide personal funds to pay employees or other pressing business expenses, document the additional funds as either a loan or an additional investment into the company.
Second, directors, officers and controlling shareholders (or members and managers of an LLC) have a general fiduciary duty of loyalty and integrity that should govern all their corporate conduct. This means that as an owner of a company you should always be making decisions that are in the company's best interest. An opposite behavior would be taking actions that benefit you personally to the detriment of the company you own. If an owner violates this duty either on purpose (in bad faith) or by not paying proper attention (negligently) he may be personally liable for any consequences of his actions on behalf of the company to a business creditor.
Third, it is important to maintain adequate business capital. If your business is deliberately undercapitalized (cannot afford to pay for its operational expenses), you may become financially responsible for legal claims against your company.
To guard against some of the mistakes listed above, companies can sometimes obtain "Errors and Omissions" insurance coverage that would insulate directors and officers from legal action caused by their conduct while representing the company.
Observing Corporate Formalities
Every state has certain requirements for corporations and limited liability companies. Filing an annual statement (or annual report) is one of these requirements that applies to both types of entities. An annual statement allows the state to keep correct data about your corporation or LLC. If you do not submit annual statements and pay the required fees on time, the company can be administratively terminated. If your company is dissolved, you will lose limited liability protection. While LLCs have fewer requirements, corporations are also subject to other formalities that include holding an organizational meeting to elect officers, adopt bylaws and issue stock.
A company should also schedule annual meetings of shareholders and should keep minutes of the annual meetings with the company records. Corporations should also keep a ledger that details all shares issued to shareholders, and how much each share is worth. The bylaws detail the manner in which the company will be operated and are one of the corporation's most crucial documents.
Corporations should keep records of all payments made, payments received and all invoices and statements. You should also keep profit and loss statements and balance sheets every year. In addition, corporations should maintain documentation for business loans and the repayment terms.
Guidelines for Limited Liability Companies
LLCs have fewer formalities to worry about. But it is advisable for LLCs to observe many of the same safety measures to prevent business owners from being held personally liable. Practical guidelines include holding an initial organizational meeting, adopting an operating agreement, maintaining documentation of all business decisions, documenting finances and encouraging all of its members to have an annual meeting, minutes of which should be recorded and kept.
While a single act may not lead to piercing the veil, numerous mistakes could be costly, leading to a situation where an owner becomes personally liable for claims against the business. Different states' laws provide different levels of protection to business owners. States like Delaware, Nevada and Wyoming are very protective of the limited liability, making it very difficult for claimants to pierce the corporate veil and reach personal assets of the owners. Other states are much less hesitant to transfer the liability of the business onto its owners. This, along with favorable state tax rates, is what makes Delaware, Nevada and Wyoming so incredibly popular when it comes to forming companies.
Remember, when you form an LLC or a corporation, liability protection is one of your most important goals -- observe the simple guidelines listed above so you do not lose this valuable feature of your company.
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