piercing corporate veil

Business entities like LLCs are often promoted by attorneys for their ability to provide liability protection. These structures are designed to shield the owners of a business from personal liability for the activities of the business. This protection helps safeguard existing businesses and encourages entrepreneurship by reducing the risk to owners' personal assets. However, this liability protection is not automatic.

The concept of liability protection hinges on the principle that the law treats the business entity as a separate legal person. Owners of LLCs and corporations are generally not liable for the actions of the entity. To maintain this protection, the business must be operated distinctly from its owner(s). Failing to do so can result in “piercing the corporate veil,” exposing the owners to personal liability.

What is Piercing the Corporate Veil?

Piercing the corporate veil occurs when a court disregards the separation between the business and its owners, holding the owners personally liable for the business’s obligations. This typically happens when the owners fail to treat the business as a separate entity.

One of the most common reasons for piercing the veil is the misuse of business funds. For instance, if an owner consistently uses the business account for personal expenses like meals or groceries, it indicates that the business is not truly independent. A legitimate business entity would not pay for personal expenses unrelated to its operations.

Example Case

Sam is a home builder who sells high-end homes. To run his business, Sam establishes an LLC. One of his buyers, dissatisfied with the quality of a home, sues the LLC for breach of warranty. The buyer also wants to hold Sam personally liable, knowing that he has substantial personal assets.

Initially, Sam would be protected from personal liability because of the LLC’s structure. However, during litigation, it is revealed that Sam used the LLC’s funds to pay for personal expenses such as lunches and other non-business items. The buyer argues that Sam did not treat the LLC as a separate entity, and the court agrees. As a result, the corporate veil is pierced, and Sam is held personally liable for the buyer’s damages.

This example illustrates how failing to maintain proper business practices can lead to personal liability. Had Sam documented a draw of funds from the LLC, deposited it into his personal account, and then used it for personal expenses, the liability shield might have remained intact.

Common Reasons for Piercing the Corporate Veil

Several factors can lead to the piercing of an LLC’s liability veil, including:

• Commingling Funds: Using LLC funds to pay personal expenses or depositing personal income into the LLC’s accounts.
• Lack of Separate Accounts: Failing to maintain a dedicated bank account for the LLC.
• Undercapitalization: Establishing the LLC with insufficient funds to cover foreseeable liabilities or operating expenses.
• Noncompliance with Formalities: Ignoring the operating agreement or failing to adhere to state regulations.
• Fraud or Misrepresentation: Misrepresenting the LLC’s financial condition or ability to meet obligations.
• Informal Agreements: Making undocumented agreements or promises outside the scope of the LLC’s governance.
• Alter Ego Operations: Treating the LLC as an extension of personal activities rather than a separate business entity.
• Poor Record-Keeping: Failing to document contributions, distributions, or significant business decisions.

Best Practices to Avoid Piercing the Corporate Veil

To protect the liability shield of an LLC, follow these best practices:

• Maintain Financial Separation: Open a separate bank account for the LLC and ensure all business transactions go through it. Avoid commingling personal and business funds.
• Ensure Adequate Capitalization: Fund the LLC sufficiently at its inception and provide ongoing capital to meet its operational needs.
• Follow Formalities: Comply with the LLC’s operating agreement and state laws.
• Document All Transactions: Keep detailed records of contracts, invoices, and other business dealings. Record all major decisions, even if formal meetings are not required.
• Avoid Fraud and Misconduct: Operate the LLC ethically and transparently to maintain credibility.
• Use Funds Appropriately: Ensure LLC funds are used exclusively for legitimate business expenses. Document any distributions or payments made to owners.
• Conduct Regular Reviews: Periodically review business practices to ensure compliance with legal and operational standards.

Consult an Attorney

When in doubt, consult an experienced attorney. They can provide guidance on sound business practices and help ensure your LLC maintains its liability protections. By taking proactive steps, you can protect both your business and your personal assets from unnecessary risk.