Piercing the Corporate Veil, for Entrepreneurs, Small Businesses, and Family Businesses
What is “piercing the corporate veil” and why should small businesses be concerned about it? Veil piercing is a legal construct that could mean trouble for small business owners who incorporated but did not know how to protect themselves from personal liability for the actions, failure to act, the products made, distributed, or sold by their company, or their company debts. Small businesses that are closely-held corporations are most at risk for having the corporate veil pierced.
Find out how you need to manage your corporation to prevent the possibility that plaintiffs could pierce the corporate veil and hold the owners or shareholders individually and personally liable. This article is from the office of a noted Philadelphia appeals attorney.
What Does Piercing the Corporate Veil Mean?
Courts have the power to put aside corporate limited liability and hold a corporation’s shareholders or directors personally liable for the corporation’s actions or debts.
The law regarding veil-piercing varies by state, but as a general principle, there is a strong presumption against piercing the corporate veil. One benefit of incorporating is that it confers limited liability upon the directors and owners for the actions or debts of the corporation, which as a matter of public policy encourages investment, innovation, liquidity, and diversification. To further these policy goals, courts will only allow veil-piercing when there has been serious misconduct on the part of the corporation.
What are the red flags that may warrant veil-piercing?
- Intermingling personal and corporate funds or other assets;
- Undercapitalization at the time of incorporation;
- Excessive control of the corporation by one shareholder or director who is using the corporation as its alter ego;
- Evidence that a director or shareholder used the corporation as their agent to conduct individual business;
- Evidence that a director or shareholder used the corporation to perpetrate fraud, and the corporation committed actual fraud;
- A parent company has multiple subsidiary companies, however, they all have the same directors and shareholders, showing that the parent company used the subsidiaries as agents and they were not independent.
These factors are often accompanied by a failure to follow corporate formalities, indicating the fraudulent creation of a corporation in order to escape individual liability.
If there is fraud, wrongdoing, or injustice done to third parties by a corporation, those third parties will ask the court to consider the aforementioned factors in their request to hold individual owners or directors liable for their damages. Examples of such fraud, wrongdoing, or injustice are:
- Corporation X has debts and closes. The owners of X incorporate as corporation Y and transfer X’s assets to Y in an attempt to escape paying those debts;
- Corporation X has a money judgment against it, and transfers its assets to a parent company in order to hinder, delay, or avoid paying the money judgment;
- A subsidiary of Corporation X made, distributed, or sold a defective product, is subject to a money judgment, and the parent company closes the subsidiary in an attempt to hinder, delay, or avoid paying.
Why Are Small Businesses More at Risk for Veil-Piercing?
An incorporated business has a separate and distinct identity from that of its owners. Many entrepreneurs and family businesses incorporate to facilitate commercial ventures and to shield themselves from personal liability for corporate actions and debts. However, the corporate structure – the “veil” – is not always enough to avoid personal liability when it is merely a shell that can be “pierced” by plaintiffs.
Entrepreneurs and families owning closely-held corporations are less likely to follow the formalities of running a corporation and more likely to use personal bank accounts and mingle personal and business assets and funds. Historically, smaller, family-owned businesses tend to be less meticulous in maintaining the corporate records, often not purposefully but due to lack of resources and staff, and perhaps knowledge.
Owners of a small corporation are also more likely to commingle assets, for example, pay a personal mortgage with a check from the corporate account.
How to Minimize the Possibility of Your Corporate Veil Being Pierced
These are the steps that entrepreneurs and small businesses can take when incorporating to preserve the distinctiveness of the corporate identity from that of its owners and directors:
- At the time of incorporation, the company must have its own bank account and EIN;
- The corporation must be sufficiently capitalized to stand on its own;
- Personal and corporate assets must not be mixed;
- The company must comply with all corporate formalities such as drafting and following by-laws, maintaining stock ledgers, holding initial and annual meetings of the board of directors, and take notes (minutes) of those meetings;
- The corporation must keep records of that compliance;
- The corporation must file its annual report;
- All business activity must be documented and records kept;
- Parties doing business with the company should know that it is incorporated.
Preserve your protection from personal liability for corporate debts and actions by following these steps, and you will not have to be concerned with veil-piercing.
About the Author
Veronica Baxter is a legal assistant and blogger living and working in the great city of Philadelphia. She frequently works with Todd Mosser, Esq., a criminal appeals lawyer in Pittsburgh.