Piercing the Corporate Veil - Why It May Be As Scary as it Sounds
Have you ever heard anyone talk about “Piercing the Corporate Veil”? Just the words sound scary, don’t they?
And, as much as I would love to tell you that it’s nothing to be scared about, that’s unfortunately not the case. It can actually cause pretty scary results if it happens, and solo entrepreneurs are at the highest risk.
The purpose of this article is to teach you what you need to know about what “piercing the corporate veil” even means and steps that you can take to help avoid it.
Now, let’s get to it. You may have heard that you should form a legal entity to protect your personal assets from being subject to liability for acts in which you engage through your business. While this is generally true, and you can read more about the benefits of forming a legal entity here, what many people do not understand is that forming the entity is not alone enough to protect your personal assets.
Once the entity is formed, you must adhere to certain corporate formalities for the entity to actually be respected and for a court not to “look through” the entity and allow creditors to have access to your personal assets anyway.
Factors Considered In Determining Veil Piercing
Courts may consider a variety of different factors to determine whether to pierce the corporate veil, including the following:
- Gross Undercapitalization
- For example, forming an entity but not maintaining adequate funds in the company to meet contractual obligations or having insurance in place.
- Failure to observe corporate formalities and absence of corporate records
- For example, failing to have corporate documents such as having an LLC agreement and recording important decisions in meeting minutes or consents.
- Commingling of assets
- For example, paying personal bills from the business checking account or depositing business receipts into a personal account.
- Diverting funds from the corporation to owners
- For example, making distributions out from the company when you have knowledge that the company can’t pay its debts.
- Whether the corporation is operating as a mere façade for its owners
The factors that a court may consider vary on a state-by-state basis. In some cases, a court may determine to only pierce the corporate veil if the plaintiff can prove actual fraud. In other states, there is a lower threshold to pierce the corporate veil. Regardless, it is best practice to adhere to the formalities outlined above to ensure the court will not be tempted to pierce the corporate veil in any state.
Example
Let’s take an example. Judy forms a nutrition business and seeks to offer wellness consulting to her clients. She had fortunately read our blog post on Why Every Entrepreneur Needs a Legal Entity, and she knew it would be a good idea to form an LLC to protect her business. Judy is a resident of Texas, so she formed a limited liability company with the Texas Secretary of State.
Once Judy formed the entity, she takes no effort to develop corporate governance documents such as an LLC agreement. She pays her bills out of her personal bank account instead of a company bank account. She signs documents in her personal name instead of in her capacity as an officer or manager of her company. Further, Judy fails to capitalize her company, and she enters into a contract with a vendor in which she will owe the vendor $10,000.00. Judy then fails to pay her vendor even when she had knowledge that her company did not have the means to pay the vendor. In this case, there is risk that a court would determine to pierce the corporate veil and hold Judy personally liable for the $10,000 payment due to the vendor even though it was her business that entered into the contract.
Take the same example, but instead assume that Judy is sued for negligence by one of her one-on-one clients. Judy unfortunately failed to use one of our contract templates that would have contractually limited her liability (check out our DIY One-on-One Client Agreement template and DIY Assumption of Risk and Liability template), and the client is suing her for $50,000.00 in medical bills. The client is claiming she had to seek medical care due to a negative reaction she had to one of the supplements that Judy recommended to alleviate her symptoms. Judy again failed to adhere to any of the corporate formalities, did not capitalize her business, and failed to have any insurance in place. In this case, depending on the state in question, it is possible that a court could again look past the corporate entity and hold personally Judy liable for the $50,000.00 (if the court did indeed find that Judy was negligent in the supplement recommendation which caused harm to the client).
Litigants can often be very successful in veil piercing cases, particularly in the case of closely held businesses. Most successful veil piercing cases occur against solo-owned companies, which is why it is critically important for solo entrepreneurs or other very closely held businesses to know about these rules and adhere to them carefully.
How Can You Protect Yourself From Veil Piercing?
So, what are some concrete steps you can take to help avoid getting yourself in the hot water that Judy got herself in?
First, once your entity is formed, make sure you have proper documentation in place to govern the entity. In the case of a limited liability company, you should have a written limited liability company agreement. We have a form of limited liability company agreement that you can purchase here.
Second, keep good books and records for your entity. Record important decisions in meeting minutes.
Third, make sure your business in adequately capitalized, and do not intentionally enter into contractual obligations for which you cannot meet.
Fourth, consider getting liability insurance to protect yourself against tort claims made by your clients.
Fifth, avoid commingling personal assets with business assets. Set up a business banking account.
Sixth, do not make distributions out of your entity to yourself if you cannot meet the liabilities of your company currently at hand.
Seventh, make sure you enter into all business contracts using your business’s name, and make sure you sign the documents in your capacity as either an officer, manager, or director of the company and not in your personal capacity.
If you would like more helpful tips and information on how to get your business legally ready, click here to download our Legally Ready Guide for Health and Wellness Practitioners containing our top 15 tips to get your business ready to go!
ALTHOUGH KELLY AND KRISTIN ARE LICENSED ATTORNEYS IN THE STATE OF TEXAS, THEY ARE NOT YOUR ATTORNEYS, THEY HAVE NO ATTORNEY-CLIENT RELATIONSHIP WITH YOU, AND THEY DO NOT KNOW YOUR BUSINESS. THE INFORMATION IN THIS POST IS NOT TO BE CONSIDERED LEGAL ADVICE, AND YOU SHOULD NOT CONSIDER IT A SUBSTITUTE FOR LEGAL ADVICE. WE ALWAYS RECOMMEND CONSULTING WITH AN ATTORNEY IN YOUR LOCAL JURISDICTION SINCE THEY WILL BE ABLE TO ADVISE YOU AS TO YOUR PARTICULAR SITUATION AND ALSO PROVIDE YOU WITH INFORMATION SURROUNDING ANY NUANCES OF YOUR LOCAL LAWS THAT WE JUST SIMPLY CANNOT ADDRESS IN THIS POST. FURTHER, WE DO NOT GUARANTEE ANY SPECIFIC RESULTS.
