It is a common presumption that when a business owner incorporates their company or registers it as an LLC, they become protected from being held personally liable for any debts incurred by the business. Although this may be true to a certain extent, it does not necessarily mean that a business owner is safe to take loans out from their business to pay off a mortgage on their holiday home. The protection from personal liability is not absolute, and the ‘corporate veil’ may be ‘pierced’ to hold an individual personally liable for a business’ debts.
Laws regarding the piercing of the corporate veil vary from state to state, but the there are two predominant scenarios that courts in every state look for when determining whether a shareholder or business owner should be held personally liable for their business debts: (i) whether they fail to abide to corporate formalities, so much so that the individual’s identity is so meshed with the company’s that it acts as their alter ego, and (ii) whether they undercapitalize the company. These scenarios can be utilized as a double-edged sword – either offensively, when a creditor desires to collect on a business debt owed to them, or defensively, when a debtor desires to prove that they should not be personally liable for a business debt.
It is important to note that it is not necessary that there be a glaring act such as the unaccounted withdrawal of money from the company or blatant fraudulent activity for the corporate veil to be pierced pursuant to the alter ego theory. It is often sufficient for a business owner or shareholder to become personally liable due to their failure to maintain annual meetings, preserve accurate and full records, or adopt bylaws, for instance. Such deviation away from corporate formalities, although it may seem trivial to some, can prove a lack of separation between an individual and a company, thus leading a court to believe that the individual should be held accountable for the company’s debts. Additionally, the comingling of assets between a company and its owner or shareholder, the payment of personal debts with a company’s funds, and other similar actions that indicate a unity of interest and ownership can also subject an individual to personal liability for their business debts. Essentially, if a company appears to be a mere instrumentality of its individual owner or shareholder, the individual can expect an extensive audit coming their way. It is imperative for a company to follow legal formalities to distinguish itself from its owners and shareholders and to avoid the piercing of its corporate veil.
The second scenario that may give rise to the piercing of a corporate veil is when a business lacks the adequate capitalization to operate and pay for its debts and liabilities, leaving the company unable to pay its creditors. Such undercapitalization of a company is understood by courts to mean that the owners or shareholders of the company are purposefully keeping their money out of their business in an effort to avoid liability.
Although undercapitalization alone will not suffice to pierce the veil, it is a significant factor heavily considered by courts, along with all other factors present in the case, to justify the piercing of the veil. If a business lacks adequate capitalization, courts will question the legitimacy of the business and may hold its shareholders or owners personally liable for its debts.
Overall, a company should always follow corporate formalities, remain adequately capitalized, and overall be seen as a separate legal person from its owners or shareholders. Piercing the veil of a corporation or LLC, or defending yourself from an attempt to pierce yours, can be complex and will require the assistance of a corporate attorney. TALG is experienced in litigating such matters and welcomes all related inquiries.