The primary reason that individuals choose to set up a limited liability company (LLC) or corporation (INC) is to protect themselves and their family from personal liability in connection with the operation of a business. If you come up with an idea such as selling snow removal in California or raising Kangaroos in Pennsylvania, your business might not move as fast as you’d like. However, what allows people to sleep at night is knowing that as long as they operate their business by the rules, they won’t lose their home or the most cherished possessions. Limited liability is typically available when you create distinct legal entities that separate your personal assets from your business assets, thereby limiting exposure to liability on both fronts. But what if you do not run the business by the book/law?
Long story short, the limited liability shield can be lost. The loss of limited liability protection is called “piercing the corporate veil”. Piercing the veil occurs when a court of competent jurisdiction decides not to recognize the separation between the legal entity and its owners. Limited liability can be lost allowing creditors and litigants to tap into the owners’ non-business-related assets including money and property to satisfy the company’s debts and liabilities. This can be devastating because it completely undermines the protection that the business owners intended to set up. It should be avoided at all costs.
So the question then becomes, “What causes piercing of the corporate veil”?
The number one reason is commingling business funds. In my practice I see this occur more than any other type of piercing and is a major risk. You should never commingle your business funds with your personal funds. It being an accident is still not an excuse. Commingling funds blurs the identity of the owner and the business itself. Courts interpret the commingling of business and personal money as a failure to keep the legal identities separate. If you use your business account as your personal bank account, why can’t your creditors use your personal bank account for business assets. The shield of liability protection is not a one-way street. Sometimes this happens as a legitimate mistake such as accidentally using the wrong debit card while paying for groceries. Other times it’s a matter of laziness that finds business owners in this trap. Writing a check for the landscaper or dry cleaner just because it was easier due to money in the account is exactly why the courts feel the way they do. The best way to prevent mistakes is to use more than one financial institution. Having a business account at a bank that is different than your personal account makes it much harder to accidentally do an online transfer versus writing a check and accidentally use the wrong debit card. The solution for the laziness aspect…well I don’t have one for that, unfortunately. Courts say that if you, as a business owner, did not recognize or treat your business separately, you should not be able to hide behind the shield of limited liability.
Another form of piercing occurs when the LLC or corporation does not have all their business records in order. In the internet world we live in, everyone is quick to jump online and set up their own LLC through various online companies. These services are not a replacement for competent legal advice and generally end up costing a business owner significantly more money in the end when something goes wrong. I cannot tell you how many people have called me in the past because their limited liability company is being sued or one of their partners disappeared off the face of the earth and when I ask for their operating agreement, they advise that they either don’t have one or even worse, that they don’t know what an operating agreement is. (The operating agreement is the document that advises how the business is intended to run. What happens if the business wants to grow and add a partner? Who is going to make decisions for the business? How is revenue divided? What happens if the business wants to dissolve?) They almost always tried to set up the business themselves. Without an operating agreement, the business is running without any known rules or procedures. Attorneys use this as a reason to show the court that it’s a “free for all” and that since the required documentation is not prepared, the business should not get the protection. With a corporation, the same thing applies to corporate minutes as well as having bylaws. If you are reading this blog now and realize you do not have these documents, you should reach out now and get them started. There is no better time to start than now.
Another form of veil piercing occurs when an owner is intentional or grossly negligent. If the business owner’s behavior was so extreme that it harmed the business and the Court decided that no reasonable business owner would act that way, then they will allow the veil to be pierced. If the business owner is driving a company car and gets in an accident due to being highly intoxicated, this could pierce the veil and allow a litigant to sue you both through your business and personally. The simple way to address this is if the behavior is something that an employee would normally be fired over, but because you are the owner, you will not be fired, then the veil could be pierced. This can go hand in hand with fraudulent behavior as well. If an owner has created a company for no legitimate purpose other than to commit fraud or take advantage of someone or something, the courts have determined that gives rise to piercing the veil.
If you read this blog and are thinking that you need to have your business documents or practices checked by an attorney, for a free consultation (virtual or in-person), use the link below to meet with Attorney Charles Rick to discuss your business needs. You can also contact our law offices online or by telephone at 484-272-5133.