Hundreds of years of corporate law has been established to protect business owners from the liabilities of their companies. The whole purpose of corporations, which date to beyond the height of the British Monarchy, is to establish the corporation as a separate legal person. This means that business owners typically only stand to lose their investment in this separate “person,” even if the company’s debts and liabilities are significantly more than the investment amount. Corporate owners are protected by what’s known as a “corporate veil.” However, dangerous exception exists that makes many business owners, particularly small business owners, at risk for the liabilities of the business. Business owners that act unethically or fail to maintain common business formalities can have their corporate veil pierced, and thus be personally liable for their business’s debts. This post outlines the most common ways of piercing the corporate veil that every small business owner should be aware of.
Three Common Ways of Piercing the Corporate Veil
C-corporations, S-corporations, and LLCs all have a presumption of limited liability for the owners. But although the corporate veil is usually respected, circumstances can become extreme enough to overcome the presumption of limited liability. When this happens, a court can decide to “pierce the corporate veil” and hold the owners of the business personally liable for debts of the business. This is a rare occurrence these days, but it certainly does happen, and small business owners are the ones most likely to be affected. Most courts look specifically at the following three factors when deciding if piercing the corporate veil is the right thing to do in a particular case.
1. “Alter-Ego” Theory: Failing to Maintain Separation between the Corporation and Owner
Because corporations and their owners are supposed to act as separate legal persons, courts don’t approve when owners behave otherwise. If the owners fail to maintain this formal separation, then the corporation could be deemed an “alter-ego” of its owners. In other words, the owners fail to treat the company like an entity distinct from themselves. When this happens, the owners will be liable for the actions of their “alter-ego” corporation and lose the protection of limited liability. Here are the most common formalities a business owner needs to maintain at all times to avoid a breach of the “alter-ego” theory:
- Using separate bank accounts for business funds and personal funds
- Only issuing checks with the proper business name
- Maintaining separate books and records
- Recording your actions when acting with an executive function on behalf of the business
- Holding appropriate board meetings and recording minutes
- Adopting company bylaws and ensuring officers and agents abide by them
- Ensuring corporate officers and directors actually perform their functions
If a business owner uses business bank accounts and signs checks in the name of the business, but uses those funds for personal reasons, then the business might be deemed the “alter-ego” of the business owner. LLCs have become popular in recent years because they often have fewer formalities that must be met. The “alter-ego” theory is involved in most corporate veil piercings. Many small-business owners are under the impression that merely having a business entity is enough to protect them. It is not. Every owner should seek help from a lawyer for guidance on how to make sure their corporate veil will be upheld by the courts.
2. Wrongful or Fraudulent Actions by the Owner
In many ways, courts of law are also courts of fairness. Common law often bends as needed according to the specific circumstances in order to deliver a remedy that is the most “fair.” As such, it’s no surprise that business owners will be punished for flagrantly unfair or fraudulent business practices. The majority of business owners are ethical citizens and will not have to worry about this issue. But just in case you need another reason to run your business ethically, this is a good one. Here are common actions that you should avoid:
- Recklessly borrowing and losing money
- Making business deals knowing that the business cannot afford them or uphold them
- Fraudulently representing the business or its financial affairs
- Concealing or misrepresenting the business’s owners or members
3. Causing Creditors to Suffer an Unjust Cost
This one is a fairness factor, similar to wrongful or fraudulent actions, as discussed above. On certain occasions, if a creditor of a business suffers a cost that is unjust, a court might also say it is wrongful and force the business owner to pay back the debt from his or her personal assets. Here, courts will be more inclined to pierce the corporate veil if the business has no money while it is creating large liabilities for itself. The two most common causes of unjust costs to creditors are:
- Creditors left unpaid because a business was unreasonably undercapitalized
- Businesses so undercapitalized they were never intended to operate separately
Owners often take money or other assets out of their business to make it a less desirable target for a lawsuit. If a creditor or other plaintiff knows it can only get a small amount of money from a business, they might think twice before suing. But if the business owner has taken out so much from the company that it can no longer even operate on its own, a court might hold the owners personally liable. Different industries and locations have different standards regarding undercapitalization. Courts are especially hard on businesses that exceed those standards. So be sure your company remains reasonably funded in order to continue operating at all times.
Conclusion: It’s Wise to Hire a Lawyer
Businesses often take on huge liabilities, sometimes without even being aware of them. Often, these liabilities can come out of nowhere and be no fault of the owners or operators of the business. In some circumstances, the court will decide to overlook the company’s limited liability and hold the business owners liable for debts or lawsuits. The three most common situations where this occurs are:
- When the business owners fail to maintain separation between the company and themselves
- When business owners commit fraud or act unethically
- When business owners undercapitalize their companies and cause creditors to suffer an unjust cost
The corporate veil will shield you from personal liability in most circumstances, but only as long as you follow the law. Keeping up to date with changes in the law and upholding all the formalities of a corporation can be time consuming and complex. This is why hiring a business lawyer can give you some peace of mind and ensure you won’t end up on the hook for big business debts.
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