Veil-piercing—often called “piercing the corporate veil” or “piercing the LLC veil”—is a judicial remedy that a court can use to set aside limited liability and hold the owners personally responsible for business actions or debts. This article discusses veil-piercing and gives practical guidance for avoiding veil-piercing claims.
The liability protection offered by a corporation or LLC depends on entity status. Entity status means that the business entity has legal rights and obligations that are separate from its owners. Acting through its owners and managers, the entity can own and manage assets, incur debts, assume obligations, and be held responsible for its actions.
Because the law recognizes LLCs and corporations as entities, it is the business entity—and not the owners—that is responsible for debts of the business. If the business loses a lawsuit, the plaintiff must look to the business to satisfy the judgment. Assuming the LLC or corporation is properly formed and operated, the plaintiff may not enforce the judgment against the owners.
Example: You form an LLC and use it to contract for consulting services. A dispute arises for breach of a consulting agreement and you lose in court. The plaintiff can only look to the LLC to satisfy the judgment. The plaintiff may not enforce the judgment against your home, personal bank accounts, or other assets.
Because the liability protection offered by corporation and LLCs depends on its status as a separate legal entity, it is important for the owners to treat the business as a separate entity. To maintain protection, owners must operate the business like a business. Protection can be lost if the owners mix personal and business funds, fail to properly capitalize the business, or do not have the right documents in place. When that happens, a court may use a remedy called piercing the veil to disregard the liability protection of the corporation or LLC and enforce a judgment against the owners.
How do Courts Peirce the Veil of Liability Protection?
Because the law favors liability protection, courts should only use a veil-piercing remedy in egregious circumstances. Most veil-piercing cases involve misconduct by the corporation or LLC or an attempt to defraud creditors (for example, by leaving the business under-capitalized or mixing business and personal assets).
Different states have different standards for veil-piercing. In Texas, for example, the veil may be pierced if any of the three “veil-piercing strands” are met:
- The corporation is the alter ego of the parent corporation or the shareholders;
- The corporation is used to avoid legal limitations upon natural persons or corporations; or
- The corporation is a sham to perpetrate a fraud.
The court will pierce the corporate veil if any of the three strands are met. The court will also pierce the corporate veil for actual fraud.1 The same standards apply to LLCs.
Similarly, in Florida, a court will pierce a corporate veil upon a showing that the corporation is only the alter ego or mere instrumentality of the parent corporation or its shareholders or that the alleged parent company or shareholders also engaged in improper conduct.
Protecting Against Veil-Piercing
The best protection against veil-piercing is to be sure that the corporation or LLC is operated like a business.
- Keep Governing Documents on Hand. Company documents should be maintained and on hand for inspection. For an LLC, these documents include, at a minimum, the certificate of formation, operating agreement, and organizational minutes and resolutions. For a corporation, the required documents include the articles of incorporation, bylaws, and minutes and resolutions of all corporate decisions.
- Be Sure the Business is Adequately Capitalized. The corporation or LLC should have enough funds on hand to pay its foreseeable debts and obligations. If you strip the equity out of the business and leave it on the verge of insolvency, a court is more likely to pierce the veil.
- Use the Business Name in Business Documents. The LLC will not protect you against contractual claims if you list yourself instead of the business as a party to the contract. Although there are situations where your name will also need to be listed on documents—for example, to personally guarantee a loan—you should always include the name of the LLC on business documents and include your name only when strictly necessary.
- Keep Adequate Books and Records. The acts of people can be observed; the acts of businesses must be documented. Every business decision—from opening a bank account to purchasing or selling assets to hiring employees or contractors—must be adequately documented.
- Keep Funds Separate. The business should have its own bank account for business funds. That bank account should be used to pay business expenses, not personal expenses. If the owners need funds from the business bank account, make sure there are enough funds to pay the owner without compromising the ability of the business to pay its debts, then make a distribution to the owner. Do not pay the owner’s expenses from the business bank account.
Following these simple guidelines will help reduce the risk that a court will disregard the liability protection that you have in place.
- In Re Jns Aviation, LLC, 376 B.R. 500 (Bankr. N.D. Tex. 2007). A corporation is used in actual fraud if all of four the following factors occur: (a) a party conceals or fails to disclose a material fact within the knowledge of that party; (b) the party knows that the other party is ignorant of the fact and does not have an equal opportunity to discover the truth; (c) the party intends the other party to take some action by concealing or failing to disclose the fact; and (d) the other party suffers injury as a result of acting without knowledge of the undisclosed fact. Id.