When can a creditor pierce the corporate veil?
Understanding Corporate and LLC Liability
Corporations and LLCs possess their own legal identities. It is the corporation or LLC that holds ownership of the business, along with its assets, debts, and liabilities. Shareholders or members own the corporation or LLC, and their financial responsibility is limited to their initial investment.
Limited Liability
The principle of limited liability for shareholders and members is a well-established and respected concept. Legislators and judges recognized that without this protection, few individuals could afford to start or invest in new businesses, knowing they could lose everything if the business failed. However, there are exceptions to this rule, one of which is the legal concept known as “piercing the veil” (commonly referred to as piercing the corporate veil, but applicable to LLCs as well).
What is Piercing the Veil?
Piercing the veil is a legal remedy that allows courts to disregard the separate existence of a corporation or LLC. When this occurs, the shareholder or member may become personally liable for the debts of the business.
This issue can affect businesses of any size but is most frequently observed in corporations or LLCs with one or only a few owners, particularly when they are unable to settle a debt. Typically, a creditor will first sue the corporation or LLC for the unpaid debt. If the entity fails to pay, the creditor may then sue the shareholders or members, requesting the court to pierce the veil and hold them personally accountable.
Criteria for Piercing the Veil
When deciding whether to pierce the veil, courts apply various tests. One of the most commonly used tests examines two main factors:
Unity of Interest: Is there a unity of interest between the corporation or LLC and its owners, leading to the dissolution of their separate identities?
Fraud or Inequitable Result: Was the corporation or LLC utilized to commit fraud or achieve an unfair result?
Unity of Interest Test
The unity of interest test essentially assesses whether shareholders or members acknowledge that the corporation or LLC owns the business. Courts will consider several key factors:
Undercapitalization: This does not simply mean the corporation or LLC was unprofitable. Instead, it refers to the lack of sufficient capital provided by shareholders or members to enable the business to function normally and meet its anticipated obligations.
Personal Use of Business Assets: If shareholders or members use the business's assets for personal purposes, it indicates a lack of respect for the entity's separate existence. For instance, using a company car for personal errands is a red flag.
Personal Expenses Paid with Entity Funds: Paying personal expenses from the corporation or LLC’s bank account severely undermines the entity's separate existence and is often a primary reason for the inability to pay debts.
Compliance with Governance Requirements: Courts will evaluate whether formalities, such as holding shareholder and director meetings, issuing stock, keeping minutes, and documenting actions, have been followed. While LLCs can operate more informally, maintaining records and conducting meetings demonstrates respect for the entity's existence.
Additionally, courts may check for adherence to other compliance requirements, such as filing annual reports, obtaining business licenses, and appointing a registered agent who is not a shareholder or member. While failing to meet these requirements alone may not warrant piercing the veil, it serves as evidence that the entity’s separate existence might not be respected.
Evidence of Inequitable Results
A court will pierce the veil only if failing to do so would lead to an injustice. This goes beyond merely showing that a creditor will not be paid; it involves demonstrating that the corporation or LLC was misused to commit fraud or achieve an improper purpose. For example, if shareholders or members established the entity while knowingly underfunding it to avoid fulfilling contractual obligations, or if they intentionally transferred the company's assets to evade a known creditor, this could justify piercing the veil. Our office can effectively address any legal questions for your business. If you have any questions, please fill out the following form below and a Business Lawyer from our office will get back to you.
