One of the main benefits to operating a business is the concept of limited liability. Limited liability means that the owners of the business entity, such as a limited liability company, are not personally liable for the obligations of the entity. Generally speaking, so long as the business entity is operated with a degree of disconnectedness between the owners of the entity and the entity itself, the owners are not liable. Thus, so long as the owners follow the rules, if the business is sued, only the assets and property of the business are at risk, but not the personal assets and property of the business owners.
The concept of piercing the corporate veil, though, can find the business owners personally liable for the obligations of the entity. A court will allow the piercing of the corporate veil if the business owners have failed to separate corporate and personal operations. The effect of piercing the corporate veil is to remove the concept of limited liability. If the corporate veil is pierced, then the business owners may be found personally liable for the obligations of the business entity, this eliminating the concept of limited liability.
What actions may permit piercing the corporate veil?
- A failure to follow corporate formalities
- Lack of sufficient capitalization
- The business entity was formed to achieve fraud
- Ongoing failure to document transaction between the business owners and the business entity
- General failure to separate the financial records and transactions between the business owners and the entity
Generally, these factors apply to both LLCs and corporations, though the case law surrounding piercing the corporate veil of LLCs is not as a robust as that covering corporations.
So, what does a business owner need to do to avoid a piercing the corporate veil? If a business owner simply forms a limited liability company and nothing more, piercing the veil is likely to be permitted. A business owner must follow corporate formalities, such as having meetings, documenting transactions, and so forth. A business should have insurance. A business owner should not co-mingle personal and business funds. A one-time mistake is not sufficient, but if the business owner continually uses the bank account of the business for personal expenses, a court may find sufficient failure to separate the finances of the owner and the entity and allow for piercing the veil. If a business owner declares bankruptcy to avoid creditors, then turns around and forms another substantially similar business, a court is likely to find this a fraudulent formation and permit piercing.
A major benefit of forming a business entity is the concept of limited liability. Business owners must ensure that they do not lose this protection via a court finding that permits piercing the corporate veil and eliminating limited liability. If you are a business owner concerned about how to properly run a business to avoid piercing, or considering starting a business and want to ensure you are doing things properly, please contact Benjamin Long of Schmidt & Long.