What is Piercing the Corporate Veil?

Piercing the corporate veil — that’s a scary phrase to a business owner. After all, most entrepreneurs create a corporation or LLC because the business entity helps protect them from personal liability. And if that protection is compromised, what then?

While piercing the veil sounds like — and is — a serious issue, it’s one you can usually avoid. In this guide, we’ll cover the basics of the corporate veil, including what it is, how to pierce it, and how you can protect your business’s limited personal liability.

What is piercing the corporate veil?

“Piercing the corporate veil” is a term used to describe the scenario when a court rules that a plaintiff can go after the personal assets of the owner(s) of a limited liability company or corporation. Ordinarily, this doesn’t happen; creditors can usually only come after the assets of the business itself because the corporate veil protects the business owners.

But in some circumstances, a court may rule to pierce the corporate veil so a plaintiff can seize assets from the business owners’ personal assets. This could include the owner’s personal savings, home, vehicle, etc. This scenario primarily occurs because the business entity broke or ignored state statutes in some way.

How do I know if my business has a corporate veil?

If you just start a business on your own (or with a friend) without filing any paperwork, you’re operating as a sole proprietorship or general partnership. These are legitimate business types, but they don’t have a corporate veil or personal asset protection. If your business gets into legal trouble, a creditor could seize your personal belongings to pay your debts.

In contrast, a business structure registered with the state like an LLC, which has “limited liability” in its name, has a corporate veil. Its owners are usually shielded from liability because the business is a separate legal entity. Corporations also offer this protection. It’s one of the primary reasons some small business owners decide to incorporate.

Piercing the Corporate Veil Examples

Every state has its own specific guidelines for businesses, so each state also has different court proceedings for business lawsuits. We can’t cover every state here, but here are a few notable examples.

• Texas: In a dispute between Nick Corporation and JNS Aviation, LLC, Texas courts ruled that the corporate veil of JNS Aviation was invalid in part because the business was formed under an improper pretense: to avoid state property taxes.
• Florida: In a notable case, Olmstead v. Federal Trade Commission, Florida courts ruled that the plaintiff could seize the ownership rights and personal assets of the owner of a single-member LLC. Ultimately, the LLC’s owner was held personally liable because the LLC committed fraudulent actions: a credit card scam.
• Iowa: In the proceedings surrounding Woodruff Construction, LLC v. Clark, Iowa courts ruled that while the defendant had appropriately funded his business and was not committing actual fraud, the plaintiff still won. This ruling occurred because Clark did not keep his business books completely distinct. He paid personal debts with the business account, compromising his corporate veil.

In general, a court will only rule to pierce a corporate veil if the business owner(s) perpetrated some kind of legal error. But every state has different criteria for what constitutes “sufficient cause” for corporate veil piercing.

If you’re unsure how your state treats questions about the corporate veil, we highly recommend consulting with a local business attorney. They can walk you through specifics for your jurisdiction.

Circumstances Where the Corporate Veil Can Be Pierced

While each state treats these cases a bit differently, there are some common reasons that an LLC’s veil might be pierced.

Fraudulent Business Practices

If an LLC commits fraud of any kind — an investment scam, a credit card fee scam, a pyramid scheme, or something else — the corporate veil will most likely be pierced. For example, let’s say a ticket company promises it has 1,000 tickets to the most popular concert in the area. In reality, it only has 900 tickets, but it takes payment from 1,000 customers.

That’s a very simplistic scenario, but fraudulent business activities like this happen. And a court could rule for the LLC’s members to pay up if the LLC itself couldn’t pay back the ticket money.

Not Treating the LLC as a Separate Entity

In some cases, a business owner will use their LLC as an “alter ego” for their own personal activities. If this happens, a court may rule that the LLC is a sham and completely indistinguishable from the person who owns it. And in turn, the owner has to pay up.

Commingling of Funds and Assets

Intentionally or not, a business owner might use their LLC’s bank account to pay a personal bill. Or maybe they’ll pay a company debt using their personal bank account. An entrepreneur with multiple LLCs might accidentally send funds from Business A to Business B’s account. Often, these mistakes are innocent and isolated incidents, and they can be corrected.

But repeatedly mingling business funds with personal funds (or those of other businesses you own) is not an innocent mistake. And courts often rule that this irresponsible mixing of accounts is sufficient cause to pierce the corporate veil.

Undercapitalization

Undercapitalization occurs when an LLC commences business without sufficient capital to conduct its normal business operations and pay creditors. It’s a common problem for small businesses who don’t properly estimate their business expenses and projected revenue.

In a worst-case scenario, a creditor’s lawyer might be able to prove that an entrepreneur knowingly started with insufficient capital. In these cases, a court might rule that the veil should be pierced.

Effects of Piercing the Corporate Veil

If a court rules that an LLC’s corporate veil can be pierced, the consequences can be pretty severe. The members become personally liable for the outstanding debts of the LLC. Depending on the personal liability protection provisions set out in the LLC’s operating agreement, one or all of the members will be liable.

A pierced corporate veil also means there’s a loss of limited liability protection. Any of your personal assets can be confiscated to pay off your debt. For example, if you don’t have enough money in your bank account to pay the court settlement, a creditor could come after your home or your car to make up the difference.

Depending on the circumstance, you might face additional legal and financial consequences. You might lose industry licenses, or you might have a difficult time getting loans from financial institutions in the future.

How to Avoid Piercing the Corporate Veil

Thankfully, it’s possible to avoid having your corporate veil pierced. To put it briefly: run a compliant, legal LLC, and you’ll enjoy personal asset protection. But here are some key focus areas to stay compliant.

Properly maintain your LLC’s formalities

Each state has slightly different annual requirements for an LLC, but it’s important that you adhere to them. That might entail filing your annual report, maintaining a state business license, or creating and following an operating agreement. Be sure to know and follow all of your state’s LLC requirements.

Ensure adequate capitalization

Do your due diligence to start your business with adequate capital to succeed. While you can’t predict every single expense you’ll incur, you should be able to budget responsibly.

Additionally, make sure your business maintains adequate capitalization by making distributions only when appropriate. Basically, don’t pay yourself from your LLC until the LLC has paid its own bills.

Keep detailed business records

Even though an LLC doesn’t have the same record-keeping requirements as a corporation, you should still keep detailed records. For example, you should keep tax records, a copy of your operating agreement, records of filed annual reports, proof of the distributions you’ve made, and more. These records help establish proof that you’ve properly maintained your LLC and operated as a compliant business.

Avoid making personal guarantees

Banks are usually reluctant to give loans to new businesses, so they’re likely to ask you to make a personal guarantee on a loan before approving it. That simply means that, if the business defaults on the loan, you’ll be expected to pay it back with your personal funds. In a case like that, the corporate veil won’t protect you because you’ve entered into an agreement to repay the loan yourself.

By the same token, remember to sign any contracts for the business as a representative of the LLC, not as yourself personally.

Seek legal advice

If in doubt, get the help of a business lawyer to answer your business questions. Even though hiring an attorney might seem expensive up front, their expertise can help you avoid thousands in lawsuits down the road. As they say, better safe than sorry.

We can help!

Protecting your corporate veil requires running a perfectly compliant business. At ZenBusiness, we can help you achieve that. Whether you need an Employer Identification Number (EIN) to get a business bank account, a registered agent for service of process, or an easy way to manage your business finances, we’ve got you covered.

Disclaimer: The content on this page is for informational purposes only, and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.