Suing to Pierce the Corporate Veil

When two or more people wish to form a for-profit business, they have choices of what business structure to use. Whether or not they intend to do so, a partnership will be created unless the people take steps to create a different kind of company.

One of the disadvantages of a general partnership is that the partners can be held individually and jointly liable for any losses or debts incurred by the partnership. For example, if a creditor sues the partnership for payment and does not have enough money to satisfy the debt, the creditor can take the partners’ personal property and real estate.

One of the advantages of forming a business as a corporation or a limited liability company (LLC) is that, unlike with partnerships, the owners and investors in corporations and LLCs are not liable for the debts and liabilities of the company – they have immunity.

This is because the law considers corporations and LLCs to be legal “persons,” separate and distinct from the owners of an LLC or its shareholders in the case of a corporation. A corporation or LLC is liable for its debts and other legal obligations. The owners and shareholders are protected from personal, individual liability for the debts and liabilities of the corporation or LLC.

“Piercing the corporate veil” refers to the act of a court taking away the shareholders’ or owners’ immunity and holding them personally responsible for the debts and liabilities of the business. If a court pierces the corporate veil, it treats the business as if it is not a corporation or limited liability company, and a creditor can go after the shareholders or owners to satisfy unpaid debts and other liabilities.

When Does Piercing the Corporate Veil Happen?

Piercing the corporate veil is most often done in cases of small, privately held business entities, such as closed corporations or LLCs. Close corporations and LLCs have few shareholders/owners and limited assets. A court might pierce the corporate veil if maintaining the separation of the corporation or LLC from its shareholders or owners would promote fraud or other unjust results.

A traditional, large, publicly traded corporation will rarely have its corporate status disregarded because the shareholders have no effective control over the operations of the corporation, and it would be unfair to burden them personally with company debts and liabilities when they had no opportunity to direct them.

In addition, large publicly traded corporations are rarely run with the kind of informality that would lead to piercing the corporate veil. Most corporations have corporate counsel who can advise the corporation daily as to how to operate cleanly and limit its risk.

How Do Courts Determine If They Should Pierce the Corporate Veil?

Before piercing the corporate veil, a court will look at the following factors:

• Have the owners failed to maintain separation between the corporation’s finances and the owners? If the owners’ or shareholders’ finances are co-mingled with the business’s finances, then a court is more likely to conclude that it is fair to pierce the corporate veil
• Has there been fraud? Is it clear that the corporation was a sham set up to carry on fraudulent activity?
• Was the corporation inadequately capitalized? When it is formed, corporate law says that a true corporation will be adequately capitalized. This means it must have funds to operate, both at its start and continuingly.
  • Corporations are usually capitalized through an initial investment of money or other assets. Other types of capitalization include liability insurance coverage, loans to the corporation, and other equity.
  • A court may find that a corporation’s capitalization is inadequate if it is too small concerning the nature of its business and the risks that go with the business. A court is more likely to pierce the corporate veil if the corporation appears to have been inadequately capitalized.
• Have the owners failed to observe the legally required corporate formalities? If the owners and directors fail to observe legally required corporate formalities, such as holding regular meetings of the board of directors and documenting the meetings, a court is more likely to pierce the corporate veil.
• Have the owners and shareholders used corporate assets as if they owned them personally? Owners should not use the business’s offices, equipment, money, contact lists, or software for personal purposes. They should not pay personal bills from corporate bank accounts or use their business computer for personal purposes.

Piercing the corporate veil is a matter of state law, so courts in different states will weigh these factors differently. Some state courts might place more emphasis on certain factors than other state courts. An experienced business lawyer in the state where the business is located will know how courts view the factors in their state.

Will I Have an Easier Time Convincing a Court to Take Away a Small Business’s LLC Status?

Courts are more likely to pierce the corporate veil of a small business than a large one because small businesses are more likely to be actual alter egos of their owners, and this will be evident in their operations.

Often, a small business operates without following the legally required corporate formalities. This makes it seem like it is not a true business since the owners aren’t treating it like one.

A business must maintain a separate identity from its owners by holding regular board meetings and keeping business and personal finances separate. If these formalities are not observed, a court will likely view an LLC or S corporation as a sham corporation rather than one that is legitimate in its operations.

Is a Large Corporation Immune From Losing Its Status?

No. Courts might pierce the corporate veil of a large corporation when owners or directors create subsidiary corporations that are essentially sham corporations created to serve the parent. The subsidiary corporations are often used to transfer debts from the large corporation to the subsidiary to shield the parent corporation’s assets from debts it wishes to avoid.

Courts will sometimes pierce the corporate veil to hold the parent liable for the subsidiary’s obligations. The factors considered are similar to those used where a person seeks to make owners or shareholders liable for the obligations of a corporation.

A court will see if the interests of the two entities (parent and subsidiary) are truly separate. Of course, if they are not, the court is more likely to pierce the veil. On the other hand, if circumstances exist to prove that treating the two entities as separate would perpetuate an injustice, the court will refrain from piercing the corporate veil.

Do I Need the Help of an Attorney to Declare an LLC a Sham?

Yes. Piercing the veil of an LLC or corporation takes a lot of legal experience and knowledge. An experienced corporate lawyer is necessary. Since corporate laws change from state to state, you should choose to hire someone from your own state. If you have a significant legal issue with a corporate business, you want a knowledgeable local corporate lawyer representing your interests.