One of the main reasons business owners form corporations and limited liability companies (LLCs) is to avoid personal liability for debts and liabilities of their business. Generally, business owners are protected from the debts and liabilities of their corporation or LLC because these entities are considered separate and distinct from those who own them (owners of an LLC are referred to as members, and owners of a corporation are shareholders).
Despite this, in some circumstances courts will “pierce the corporate veil” and hold an LLC or corporation’s members/shareholders personally liable for the debts and liabilities of the business. This is the most frequently litigated matter in corporate law.
1. WHEN WILL THE COURTS “PIERCE THE CORPORATE VEIL”?
“Piercing the corporate veil” is a common-law doctrine and rests in case law precedent. While there is no bight-line rule, “piercing” is generally available when business owners (a) unreasonably commingle their personal funds with business funds, (b) fail to follow corporate formalities, and (c) otherwise treat the LLC/corporation as their alter ego instead of a distinct legal entity. Many courts have stressed that when an entity is undercapitalized this is also an important factor to consider, although it may not by itself justify “piercing the corporate veil.”
a. Unreasonable Commingling
Business owners must keep their personal assets and funds separate from those belonging to the business. The most common example of commingling funds is when an owner deposits business funds into his or her personal account, and vice versa. Neither should business owners pay personal bills and expenses with a corporate check or credit card, nor pay business expenses with a personal check or credit card. Furthermore, any loans an owner makes to the business should be documented by a promissory note or similar instrument, and member/shareholder meeting minutes approving of the terms of the loan should be memorialized. What constitutes “unreasonable” commingling is determined on a case-by-cases basis, using case law precedent to draw similarities to the case at hand.
b. Failure to Follow Corporate Formalities
Most business owners regularly neglect maintaining proper records and fail to follow corporate formalities. For example, shareholders and directors must hold regular meetings to maintain a separate and distinct identity of the company. State statutes require corporations to notice, hold, and properly document at least an annual meeting of shareholders and to approve fundamental changes and large transactions involving borrowing, compensation, and purchasing. These meeting minutes should be memorialized by the secretary and stored in a corporate binder. It is also necessary to maintain normal accounting records and financial statements for the business.
c. Alter-Ego
A court may also “pierce the corporate veil” when a unity of ownership and interest exists between the business and its controlling owner. This happens when the business ceases to exist as a separate entity and is the “alter ego” of the controlling owner, and when recognizing the owner and business as separate and distinct would result in fraud or injustice. The existence of the following facts would support the “alter ego” theory: (a) commingling personal and corporate funds and other assets, (b) issuing stock/membership interests without authority, (c) undercapitalization, (d) misrepresentations of ownership, assets, and financial interests, (e) avoiding creditors by transferring assets to owners.
d. Undercapitalization
When a corporation or LLC is formed, the members/shareholders make capital contributions to the business in the form of services, money, assets, or a combination thereof. Adequately capitalizing the new business is essential, and owners should capitalize the business to the extent necessary to cover reasonably anticipated liabilities given the nature and magnitude of the business, as well as the normal operating costs and expenses of the business. Undercapitalization is generally determined when the business is formed, so a later infusion of capital is not enough to negate personal liability to the owners.
2. BEWARE OF SINGLE-MEMBER LLCS
In 1996 the IRS enacted “check the box” regulations, allowing non-corporate entities (such as LLCs) to be taxed as partnerships. However, an LLC with one member cannot be a partnership, so the IRS declared that a single-member LLC (SMLLC) does not exist for federal income tax purposes (this is also referred to as a “disregarded entity”).
Although SMLLCs may have tax advantages and are easier to maintain, it is much easier to “pierce” the veil of a SMLLC. To avoid the “piercing of the veil” issue, many corporate attorneys advise their clients to do two things: (i) create sufficient legal documentation (including a single-member operating agreement and Board of Manager resolutions, etc.) to reflect that the single-member LLC is indeed a separate entity and has been treated as such; and (ii) if there is significant liability exposure, issue a small equity interest (e.g., 2%) to a close relative. Issuing a small equity interest will create a multiple-member LLC — in which case it will not be a “disregarded entity” for tax purposes.
If you have any questions or concerns regarding these matters, please do not hesitate to contact the Law Offices of Tyler Q. Dahl.
Disclaimer: This material was prepared for general informational purposes only, and is not intended to create an attorney-client relationship and does not constitute legal advice. This material should not be used as a substitute for obtaining legal advice from an attorney licensed or authorized to practice in your jurisdiction. You should always consult a qualified attorney regarding any specific legal problem or matter.
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