Piercing the Corporate Veil

The Small Company in Turbulent Economic Times

In these tough economic times, many owners of small businesses are scrambling to keep their company afloat. This often means using personal savings to pay company debt. The last thing a small business owner wants if the business ends up shutting its doors, is to be held personally liable for the company’s debts. Whether you own a small business or a large corporation, you could get caught “holding the bag” if the company goes under. It is, therefore, crucial to understand when a company’s owners can be held personally liable for its debts.

On the other end of the spectrum is the person or business who provides services or goods to a company and does not receive payment. Suit may be filed and judgment obtained against the defaulting company, but when collection is attempted, it turns out the company is “defunct” and has no assets. Meanwhile, the former owner uses revenue and contacts obtained from the defunct company to create a new company. You are left with an uncollectible judgment and the business owner goes his merry way to repeat the procedure with other vendors.

A “corporation” or a “limited liability company” is a legal entity, separate and distinct from the people who create it. Corporations are owned by “shareholders” and limited liability companies by “members” who own all or part of the company depending on the number of “shares” or “memberships” they hold. Smaller businesses tend to be owned by just a few people – often only one person. These types of businesses are called “closely held corporations” or “close corporations” for short.

One of the principal advantages of forming a corporation or a limited liability company (“LLC”) is that both the managers and the owners have limited liability for the company’s debts. Unlike partnerships and sole proprietorships, the people who own and run the corporation generally are not personally responsible for the debts of the business. However, in some circumstances courts can ignore the limited liability status of a corporation or LLC and hold its officers, directors, and shareholders or members personally liable for its debts. This is often referred to as “piercing the corporate veil.”

Courts will generally pierce the corporate veil and impose personal liability on officers, directors, and shareholders or members when: (1) there is a unity of interest between the company and its owners; (2) the company’s actions are wrongful or fraudulent; and (3) the company’s creditors suffer an unjust cost. Courts will only impose personal liability on those individuals who are responsible for the corporation’s wrongful or fraudulent actions, and will not hold innocent parties personally liable for company debts.

The most common factors that courts consider in determining whether to pierce the corporate veil are: (1) the existence of fraud; (2) failure to adhere to corporate formalities; (3) inadequate capitalization; and (4) abuse of the corporate entity so as to amount to complete domination. Some corporations may be especially vulnerable to violating the above factors inadvertently, simply because of their size and business practices.

Closely held companies tend to be more susceptible to losing limited liability status than large, publicly traded corporations. One reason for this is that smaller corporations are less likely to observe corporate formalities than their larger counterparts. When it comes to corporate formalities, it’s best to play it safe. Hold an annual meeting of directors and shareholders or members and keep accurate, detailed records, called “minutes,” of what occurs at the meeting. Company bylaws should be formally adopted, and officers and agents should abide by those bylaws. Small business owners may also co-mingle their personal assets with those of the corporation, or they may divert corporate assets for their own personal use. For example, the owner may write a check on the company account to pay his or her mortgage or car repair, or an owner may deposit into his or her personal account a check made payable to the company. Courts refer to this as “commingling of assets.” The company should maintain its own bank account and the owner should never use the company account for personal use or deposit checks payable to the company in a personal account.

Large corporations are not immune from losing their limited liability status either. Often, a court will pierce the corporate veil of a large corporation when the officers and/or directors create a subsidiary corporation to transfer away liability. One common scheme employed by large corporations is to incorporate several undercapitalized subsidiaries. The large corporation (called the “parent corporation”) finances the operations of the subsidiaries, and exerts substantial domination and control over the activities of each subsidiary. Such subsidiaries are commonly called “dummy corporations” or “corporate shells” because when creditors seek to collect a debt from (or enforce a judgment against) one of the undercapitalized subsidiaries, the subsidiary is unable to pay and the parent corporation is not liable. In those cases, courts will pierce the corporate veil of the parent corporation to prevent the creditor from suffering unjust cost.

To avoid becoming personally liable for corporate debts, you should:

Observe corporate formalities.
Never co-mingle your personal assets with those of the corporation.
Never divert corporate assets for personal use.
Never represent to a creditor that you will personally guarantee payment of the corporation’s debts.
Never use the company to engage in illegal, fraudulent or negligent acts.
Always maintain a separate bank account for the company.
Make a reasonable initial investment in the corporation so that it is adequately capitalized.

If you have provided goods or services to a company that refuses to pay and has become “defunct,” and you have evidence that the company engaged in any of the activities described above, you may be able to pierce the corporate veil and obtain a judgment against the owners of the company.