What is Piercing the Corporate Veil is Finally Defined

While it’s rare that someone has to deal with matters in regards to piercing the corporate veil, it does come up occasionally. The best way to prevent this legal scenario is to avoid it entirely with careful business planning.

How to Avoid Piercing the Corporate Veil

1. Structure Business Accordingly
2. Don’t Mix Assets
3. Hire a Registered Agent
4. Create a Documentation and Filing System
5. Don’t Engage in Unethical Business Behavior

If you ever watched the classic movie The Wizard of Oz, you might remember the scene where Dorothy and her band of unlikely friends discover that the wizard is actually a frail old man behind a curtain. Though you may not be a wizard, the metaphor is applicable to the idea of structuring your business as a separate legal entity: there is a curtain between you and any potentially aggrieved parties. They cannot touch your personal assets in a lawsuit or hold you accountable for the actions of your business.

Or can they?

What is Meant by Piercing the Corporate Veil?

Piercing the corporate veil means that a court puts aside the limited liability protection of a business to hold the directors or shareholders personally responsible for actions or debts. As you might imagine, courts are generally reluctant to do this, and are only likely to pierce the corporate veil in cases where there has been particularly egregious and unethical behavior.

If courts were trigger happy about piercing the corporate veil, not too many people would be willing to go into business. But by the same logic, if piercing the corporate veil were not possible, it would allow dishonest business owners and corporate directors to avoid their obligations by hiding behind a corporate structure.

Piercing the corporate veil is also referred to as the Alter Ego Doctrine. Generally speaking, the plaintiff seeking damages must prove that the corporation is indeed influenced by a certain person or persons, that any separation of this person or persons and the corporation never truly existed (other than on paper), and that under the current circumstances, failure to pierce the corporate veil would result in sustaining fraud of injustice. These laws do vary by state.

As you hopefully know, creating a corporation or even an LLC to distinguish your business activities and protect your personal assets is not that difficult. It’s entirely within the realm of possibility for a fraudster to leverage these legal strategies, or even for a once-scrupulous person to suddenly, for whatever reason, default on a debt or engage in unethical behavior. And while incredibly rare, it is occasionally possible for someone in the right to have their corporate veil pierced—if they made any of these unwitting mistakes:

These Steps Will Help You Avoid Piercing The Corporate Veil

1. Structure Business Accordingly

Operating a business as a sole proprietor does not come with a lot of rules and regulations. And for that matter, neither does operating as an LLC. But as soon as you structure your business or investment activity as a C corporation, there are certain formalities that become legal obligations.

Corporations must file their taxes on a quarterly basis. They must have a board of directors that oversees the direction of the company. And they must have annual meetings open to shareholders. If you are not following these requirements, it can send a strong message to a court that a corporation is not truly separate from the owners and the other individuals in question.

Pay attention to these requirements and take them seriously to avoid issues like this before they ever even occur.

2. Don’t Mix Assets

It might seem like a no-brainer to have a separate business checking account, but it’s easier than you think to mix business and pleasure when it comes to paying the bills. This is especially true if your corporation is set up as a service-based business, like consulting, marketing, technical support, or financial advising.

Are you keeping track of which expenses are personal and which ones are business related while adhering to the annual IRS publications? Are you using business funds to pay for personal expenses and vice versa out of convenience? This is where it helps to have bookkeeping or accounting software to keep a running tab of expenses. Not every business expense is 100% deductible. Some are only deductible up to a certain percentage or if certain requirements are met.

3. Hire a Registered Agent

When you run a business, you often don’t have time to deal with legal paperwork or consider deadlines. This can sometimes result in running afoul of regulatory concerns, whether they are local, state, or even federal. And if for some reason a certain party wants to take you to court, the summons might go unnoticed until it’s too late.

A registered agent can take care of these problems for you, receiving all important legal paperwork and notifying you of anything that needs urgent attention. And if your business is facing a lawsuit, a registered agent can give you ample warning to prepare. Schedule a free consultation to learn more about Anderson Advisor’s registered agent services and everything it entails.

4. Create a Documentation and Filing System

Remember to dot your I’s and cross your T’s as the saying goes. Creating a structured system for documents that relate to your business is a useful and proactive step you can use to avoid trouble from audits and the possibility of the Alter Ego Doctrine being applied to your business.

If a paper trail clearly indicates that your business is a separate entity and that you adhere to all the legal formalities of a corporation, then it is harder for the plaintiff in a case to paint you and your business as being one entity disguised by the thin veil of a corporation in name only. Part of this proactive approach is learning how to structure a business properly.

5. Don’t Engage in Unethical Business Behavior

It would seem this last one goes without saying, but sometimes it is tempting to cut corners and hope that nobody notices. Other times it may seem perfectly okay to do things that aren’t inherently illegal or unethical—such as moving corporate monies to avoid corporate debts, letting corporate capital dip below what is necessary to meet debts, and failing to capture the content of corporate meetings in minutes.

The problem with missing these seemingly innocuous details is that a plaintiff can portray them as exhibiting intent to unethically use a corporate structure as a shell.

How Often Does the Corporate Veil Get Pierced?

Cases of alter ego liability have occurred throughout history, where a corporate entity was deemed by a court (or judge, specifically) to be nothing more than a shell protecting a business owner from business debt, even if their activities were structured as a legitimate business entity.

Of course, such legal precedents did not come into play until after laws facilitating personal liability protection were created through elements like a limited liability company, limited partnership, and the corporate entity with its corporate formalities. Such rulings created a precedent in business law whereby a superior court could force an owner out from hiding behind a corporate structure to avoid a creditor from targeting their personal bank account.

One such case of personal and business assets subject to (seemingly) improper conduct for the benefit of a corporate shareholder occurred in the United Kingdom in 1875. In the case of Salomon v A Salomon & Co Ltd, the enterprise theory of keeping corporate assets distinct from the personal assets was upheld by a case that worked its way all the way up to the House of Lords. To make a long story short, Mr. Salomon was a cobbler whose sons wanted to join him in the business. To that end, he made a limited liability company to purchase his own cobbler business at excessive value, taking a loan from Mr. Edmund Broderip of 5,000 pounds sterling.

As it turned out, the shoe business went downhill shortly thereafter. Mr. Broderip was repaid his principal, but Mr. Saloman defaulted on portions of the loan interest. The liquidator of Mr. Salomon’s company argued that Mr. Salomon should be held personally responsible because the parent corporation he created purchased his shoe business at an excessive price. It was clearly all a shell game to obtain money. A high court ruled in favor of Mr. Broderip against Mr. Salomon, but The House of Lords unanimously overturned this decision—cementing the idea that the formality of creating a corporation on paper is binding, even if the one with a fiduciary duty to the corporate funds seems to be leveraging the power of paperwork to affect a personal financial goal. Their decision, in part, made it clear that an individual judge could not read into the statutes dictating corporations and their shareholders as separate entities. But plenty of other cases have arisen since then; ones that clearly illustrate willful misconduct to manipulate or deceive customers, shareholders, or others.

But as long as you have your ducks in a row and your corporate records clearly indicate that the company you’ve created is legitimate, piercing the corporate veil is unlikely. In most every state, the court needs to show that there was a clear lack of distinction between the corporation and the related entities.

Piercing the Corporate Veil is Rare, But You Still Need to Prepare

You do not want your corporate veil to be pierced. Thankfully, it’s not likely to happen unless you are actually engaging in egregious or unethical behavior. However, there is still a chance that it can happen if you have a carefree attitude to the formalities of running a corporation, effectively allowing the lawyer or legal team of a disgruntled plaintiff to convince the courts that you are not really a corporation, but just a shell meant to obfuscate activity that could put into the jeopardy of personal liability to lawsuits or creditors.

As mentioned, one of the first steps to avoiding alter ego liability is to structure your business appropriately. You can learn more about this process by signing up for our Structure Implementation Series. We’ll not only help you set up a corporate veil to limit your liabilities, but we’ll also help you set up a wealth planning blueprint to ensure your business is a success.

Bonus Video