In 2014, a Massachusetts appeals court found a sole member (owner) of a limited liability company (LLC) personally liable for damages in a breach of contract lawsuit. The appeals court summary stated that the corporate records were not kept and that the corporate veil was pierced.
This is just one example of "piercing the corporate veil," a concept and term we'll discuss below as well as the impact of this action.
What Does Piercing the Corporate Veil Mean?
The corporate shield or corporate veil is a term used to describe the separation of a business (not just corporations) from its owners for liability purposes. As a separate entity, a corporation or limited liability company (LLC) is set up to "shield" the owners of the corporation (or members of the LLC) from personal liability for the debts, negligence, or mismanagement of the business.
The concept of the corporate veil is important to the concept of limited liability. In general, if the corporation or LLC is considered completely separate from the individuals who own and manage the business, those owners/managers cannot be held responsible for the company's actions. The company and individuals are separate.
Owners of these types of businesses ordinarily have protection from liability, but this protection isn't absolute. In some cases, the corporate veil may be pierced when the owner a) doesn't treat the company as a separate business entity, or b) uses their control of the company to commit fraud or another illegal action.
Owners of sole proprietorships don't have liability protection because the business and the owner are not separate; there's no "veil" between them.
Corporations are separate entities from their shareholders, and in normal circumstances, if a corporation is sued, the individual shareholders and officers cannot be brought into the lawsuit. But there are cases in which the corporation's officers and shareholders could be sued for negligence or for debts because the corporate veil (separation) has been pierced.
The corporate veil may be pierced in cases in which a corporate or LLC officer or owner may be liable for debts of the business, including:
- For payments made with personal or business credit cards (according to the terms of the credit card agreement)
- For documents (contracts or loans, for example) signed by the owner personally and not signed by the corporation
- If an owner gives a personal guarantee for a loan or uses personal collateral (like the owner's home) for a loan.
The tax law allows the IRS to pierce the corporate veil and take action against anyone in a business who is responsible for failing to pay trust fund taxes withheld from employee pay (such as federal income taxes or Social Security/Medicare taxes). States have similar laws for failure to pay withheld sales taxes.
When Can Business Owners Be Sued Personally?
Several instances in which the corporate veil might be pierced by a court, removing the limited liability protection, include:
- The existence of fraud, wrongdoing, or injustice to third parties
- Failing to keep affiliate or subsidiary companies separate
- Failing to keep the identity of the company and its owners or shareholders separate
- Failing to adequately capitalize the company (through poor management)
- Failing to follow corporate formalities by not keeping good records
State Laws and the Corporate Veil
The ability of a business owner to use the protection of the corporate veil varies from state to state. Most states uphold the concept of the corporate veil unless the business owner has plainly abused this protection.
In Florida, for example, two factors must be present to pierce the corporate veil:
- That the business is only an alter ego or mere instrumentality of the parent corporation or its shareholders and
- That the parent company or shareholder(s) also engaged in improper conduct
Meanwhile, Alaska's state Supreme Court considers the piercing issue only when there is some control or connection to the corporate form and only where there is "misuse" (misconduct).
Texas courts, on the other hand, will pierce the corporate veil when owners intend to use the company for fraud for the direct personal benefit of the person.
Frequently Asked Questions (FAQs)
How do you avoid piercing the corporate veil?
Evaluate your activities in relation to your business. Make sure you don't have any overlap between your business and personal activities. Make sure you are keeping all your corporate records correctly and in a timely manner. If you have a board of directors, consider a conflict of interest policy to be signed by all members. Better yet, have your attorney review all of the connections between owners (including shareholders) and business activities.
How does the corporate veil work with partners in partnerships?
General partners in partnerships who participate in manage the business don't have limited liability; there's no corporate veil in these situations. Limited partners and partners in limited partnerships have the same limited liability as corporations, and violations that pierce the corporate veil are handled the same way as for corporations.
What type of law covers piercing the corporate veil?
Because corporations and other business entities are set up as state entities, many cases involving piercing the corporate veil are in state courts. If federal tax laws are violated, these cases may be tried in federal courts. Cases involving fraud or other illegal actions may be tried in criminal courts. Cases involving creditors may be handled in bankruptcy court.