Piercing the corporate veil is an important legal issue for ones who are interested in forming a Corporation or LLC and even for those who want to buy a house or real estate in the US.
As we stated in our relevant blogs on forming a Corporation and forming an LLC, these business structures including S Corporations provide limited liability to their members/shareholders and this is the most conspicuous advantage of them. When they are properly formed and maintained members/shareholders normally will not be held personally liable with their personal assets for the liabilities of the company. Furthermore, they offer several tax benefits.
What is Piercing the Corporate Veil?
The Corporate Veil refers to the separation of a corporation’s identity from its owners/members. As soon as articles of organization are filed and submitted duly, the Corporation is accepted to be established within the capacity to have rights and obligations of being a separate entity. One important caveat here is that we use Corporation term for LLCs and Limited Partnerships as well as corporation type of business structures. This is because piercing the corporate veil is not a legal problem limited to corporations. Such information found in several sources is wrong.
Piercing the corporate veil refers to a legal problem in which a court removes the separation of owners, members, shareholders, and the corporate entity and holds them liable for corporations’ debts and actions personally. For example, when an individual or another company sues a corporation claiming a debt or anything subject to compensation under normal circumstances, owners/member are not held responsible for their personal assets. Although regulations vary from state to state, one can say that courts have a strong common stance regarding not piercing the corporate veil. However, one should know that if courts conclude that the owners/members abused the corporation form and /or fraudulent activities occurred, they would pierce the corporate veil and this would result in serious consequences. Let's have a closer look at these situations below.
When Does Piercing the Corporate Veil Apply?
The most common actions/situations that could cause piercing the corporate veil are as follows:
· Fraud and fraudulent activities
If the courts determine that the corporation was established to make sham and deceitful deals and involve in deceptive activities, in other words, determine that there was no real separation of members/shareholders from the corporation’s entity, they can remove the protection and owners/shareholders might be sued.
· Co-mingling of personal and corporate assets/funds
Steering corporate assets for personal purposes without proper documentation, providing a loan or an offer request to a shareholder/member anomalously are among the most prominent examples of such misuses. Furthermore, failure to title corporate assets in the corporate name, failure to utilize separate bank accounts (e.g. performing financial transactions with personal bank accounts) or failure to record an appropriate resolution, sign a promissory note, charge a fair market rate interest in debt/credit relationships between corporation and shareholders/members or owner could cause such an inter-mingling problem.
· Lack of adherence to corporation formalities
Failure to maintain a stock ledger, hold annual meetings, record corporate minutes, make regular filings, adopt or update bylaws would be among the factors courts might consider when giving a ruling on a claim of piercing the corporate veil.
· Undercapitalization & Piercing the Corporate Veil
Corporations should have enough capital both in the formation stage and in meeting other short and long term obligations. If the corporation is not fortified with sufficient sources compared to similar companies in a similar business, a claimant can argue that raison d'être of the company was merely a cover to protect personal assets. This would also be another matter of consideration for the courts
· Domination of Shareholders over board of directors & officers
Lack of votes to approve significant decisions, failure to appoint or respect board of directors and officers are examples of this kind of domination
How to Avoid Piercing the Corporate Veil
Firstly, the aforementioned situations that might cause the removal of protection are not exhaustive. It is always possible to encounter different matters in dispute which converges on the dissolving of separation of owners/members from the corporate entity and consequently piercing the corporate veil. Nevertheless, the following recommendations would be useful to raise the corporate veil and maintain it.
· Annual filings should be performed timely and meticulously in order to keep corporate charters creditable
For example, in many states filing an annual report which indicates the names and addresses of company officials and directors is mandatory. Failure to do this may result in revoking the corporate charter.
· Determine all intra-company formalities since the very beginning of the incorporation and perform all business actions accordingly
Forming and updating bylaws would provide important guidance for a wide variety of issues ranging from the schedule of company meetings to voting regulations, from appointment/dismissal of directors and officers to decision making procedures and corporation's future strategies. All operations/actions within the corporation should be in accordance with bylaws. Rule-bound structure of the corporation would be one of the most prominent indications against piercing the corporate veil.
· Keep corporate records, maintain an up-to-date corporate minute
Since the very beginning of formation, you should record all decisions made in annual and special meetings as stipulated by bylaws. This would be another strong indicator of a separate corporate identity.
· Give prominence to your corporate identity
You should engage in all contracts, perform all business transactions and activities evidently as a corporation. Directors and officers should be able to prove that they are operating in their capacity when fulfilling their duties. Business cards, invoices, letterheaded papers, corporate web sites should reflect the corporation as a separate entity having its own legal capacity.
· Avoid undercapitalization
Although many states don’t regard insufficient capitalization as a sole reason to remove the corporate veil, it would be wise to provide the corporation with enough financial sources to pre-empt future claims regarding the piercing of corporate veil. Moreover, several states such as California are more inclined to remove corporate veil protection due to undercapitalization.
· Ensure the separation of corporate assets from personal assets and maintain it
Loans given to individuals, shared tax returns and bank accounts, personal use of corporate assets are all wrong practices that peril the separation of corporate identity from its owners/shareholders. Needless to say, lending to Officers, Directors or Shareholders would be an even worse signal.
· Avoid identical stock ownership of several corporations if you have more than one corporation
You should also refrain from having similar officers and directors. Moreover, it would be beneficial for you to use different business addresses, telephone, and employees.
As we mentioned above, removal of limited liability in corporations, LLCs and LPs aka piercing the corporate veil is a legal issue that carries the potential of bearing serious consequences. Therefore, receiving solid and reliable legal support and guidance from the very beginning of the formation of the corporation and after appears as a necessity to handle this complicated and multidimensional problem. Irrespective of your position in such a lawsuit, be it a claimant or defendant, managing the process with a subject-area lawyer would be inevitable.
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