Forming a business entity like a corporation, limited liability company (LLC), or limited partnership is a great way to protect your personal assets from the debts or liabilities of the business, but if you don't follow the rules that afford those protections, you can lose them. When you haven't properly segregated the business from your personal affairs (known as creating a "corporate veil" around the business's debts), courts can pierce the veil, also known as the corporate shield. The owners and/or shareholders can become personally responsible for the debts of the business.
Certain business structures, including corporations and LLCs, protect the owners and shareholders from personal liability for the debts and obligations of the business. However, not all business entities limit liability. Owners of sole proprietorships and partnerships are personally liable for the debts of the business. Depending on the laws of the state, limited partnerships might limit liability for one or more partners and not for others.
The difference between an entity like a sole proprietorship and an entity like an LLC is that the law considers an LLC to be an entity separate from its owners. The LLC itself holds assets and owes debts, not the owners. When the LLC is properly formed and maintained, creditors have the option to collect only from the business itself, even if the business does not have enough money to satisfy the debt. In contrast, the law does not consider a sole proprietorship to be separate from its owner. If the business owes a debt, so does the owner. Bringing a lawsuit against a sole proprietorship is the same as bringing a lawsuit against the owner.
After a court pierces the corporate veil, one or more of the company's owners or shareholders loses their liability protection. Once the veil is gone, creditors may sue and collect debts from the owners and shareholders. The owners' personal assets like their bank accounts, homes, investments, and cars will be available to pay the debt. Depending on the circumstances, such as when only one shareholder diverted assets from the business for personal use, courts might pierce the veil only for the owner involved in wrongdoing, while innocent owners will continue to enjoy limited liability. Unless the court rules otherwise, piercing the veil does not automatically dissolve the company.
Losing liability protection is not common, and courts will pierce the corporate veil only for serious misconduct or a series of actions demonstrating misuse of the business entity. The rules will vary in each state, but generally, companies invite trouble when one of the following occurs:
The section below gives more examples of business behavior that can result in the loss of liability protection for the owners.
Courts will consider the totality of the circumstances and look for telltale acts that indicate the owners misused the business entity. A single incident of company mismanagement, like accidentally depositing one business check into your personal bank account or missing one annual meeting, might not result in losing protection. A court would be unlikely to find that a single oversight indicates that the owners did not treat the business as a separate entity.
However, a series of actions might suggest the owners intentionally did not separate themselves from the business, or that the company's actions were fraudulent. With actions that would result in harm to a third party, like hiding information about the company's upcoming bankruptcy, a single action might pierce the veil.
The most common actions that result in the loss of liability protection include:
Commingling Assets: Commingling means the owners did not separate their personal assets from the business assets. The most common situation is where the business does not have a separate bank account, and the owners simply use their personal bank accounts to deposit money and make payments on behalf of the business.
Diverting Assets: Similar to commingling assets, diverting assets occurs where an owner or shareholder takes company assets without proper documentation. This includes situations where an owner takes out a personal loan from the business bank account without following company procedure, or makes a home mortgage payment with the company checkbook.
Failing to Observe Corporate Formalities: Depending on the business type and internal operating documents, companies must follow a number of business formalities. For instance, state laws require corporations to hold annual meetings and maintain records. For LLCs, failing to have an operating agreement and/or failing to follow the rules outlined in the agreement are indications the LLC did not follow necessary procedures.
Inadequate Capitalization: Inadequate capitalization means the business does not have enough money for the owners to adequately run the business. This situation alone will not pierce the veil, but it is a sign that the company's actions were fraudulent or created as an attempt to hide assets from creditors.
Personal Guarantees: Business owners might lose liability protection if they frequently personally guarantee business loans or contracts. Although the business will use money or services, a personal guarantee means an individual will be on the hook if the business does not fulfill the obligation. Similarly, if an owner uses his personal credit card to pay for a business asset, the owner will be responsible for paying the credit card. While a one-time use of a personal credit card or a personal guarantee will not result in a court piercing the corporate veil, regularly engaging in these practices demonstrates a failure to keep personal and business assets separate.
Misrepresentation to Third Parties: A court might pierce the veil if the owners make misrepresentations to third parties, such as hiding information about the company going bankrupt.
To avoid losing your liability protection, understand that your company is a separate legal entity from your personal financial life and not a vehicle to hide assets from creditors. Treat the business assets as separate from your personal assets, and familiarize yourself with the business laws of your state, as well as the language of your bylaws and operating agreement. Finally, when you communicate with third parties, be honest about the state of the company.