When you organize a business entity, one of the main considerations is liability. Who should be held responsible for damages or debts caused by the business’s actions? Should the owners, members or shareholders be liable? Or is the business its own entity that is solely responsible for its liabilities and debts?
If you want to limit the owners’ liability for business actions and debts, the most straightforward way is to set up a corporation or limited liability company (LLC), or some similar entity. This puts consumers, contractors and suppliers on notice of the limitation on liability.
However, simply organizing as a corporation or LLC is not enough to limit the owners’ personal liability for business debts. In some cases, courts will strip the entity of its liability-limiting properties and hold the owners liable despite the corporate/LLC formation. This is called “piercing the corporate veil.”
Courts generally recognize corporations and LLCs as entities that are separate from their owners. They have the authority to pierce the corporate veil, but they generally hesitate to do so.
Nevertheless, there are situations where courts will pierce the corporate veil, which could mean liability for you. The main situations where this could happen, according to a Yale corporate and securities law professor, include:
- When the owners fail to observe the formalities required of the business entity
- When the business entity is merely an “alter-ego” of its shareholders; there is no substantive difference between the business and its owners
- When the business entity is undercapitalized, in rare cases
- To bring corporate actors into conformity with a clear public policy
- When the business entity is being used to promote fraud, injustice or illegality
- When the shareholder/member has misled another party to believe that a particular obligation is a personal liability
- To prevent preferential transfers and fraudulent conveyances in bankruptcy
To prevent your company’s corporate veil from being pierced, the first step is generally to make sure that you are following the required formalities for corporate operations, for example:
- Creating an incorporation agreement and corporate bylaws
- Issuing stock to shareholders
- Setting up a board of directors
- Appointing corporate officers, including a president, treasurer and secretary, who will operate in the best interest of the shareholders
- Requiring at least one board meeting per year
- Keeping an accurate record (i.e. minutes) of board meetings and decisions
- Keeping corporate funds separate from private assets (e.g., never paying private expenses from a corporate account or vice-versa)
- Having board consent for all corporate-level contracts and agreements
- Paying dividends, if required by the bylaws
There are also required formalities for operating as an LLC.
If you have questions about corporate governance or piercing the corporate veil, talk to your business attorney.