A business will select a certain business entity at the time of formation for a variety of different reasons. One of the most important reasons businesses elect a certain type of business entity is to protect owners and investors from personal liability. Business entities such as corporations and limited liability companies (LLCs) remain attractive because they protect owners, investors, members, etc. from personal liability. On the other hand, entities such as a sole proprietorship or partnership leave owners open to personal liability for corporate debts.
Yet, while limited liability protections exist for corporations and limited liability companies, these protections are not impenetrable. Rather, personal liability may, in some circumstances, run through the company and attach to its owners and investors. This is called “piercing the corporate veil” and it is something of which all businesses, whether starting out or established, should be well aware.
How Can the Corporate Veil be Pierced?
As mentioned above, limited liability is not without its limits. Piercing the corporate veil is a court-ordered remedy given to unpaid creditors. This remedy allows creditors to circumvent the limited liability protections of the business entity and look to the personal assets of owners, investors, and stockholders so that they may recover those debts owed.
However, the remedy is not without requirements. Creditors will not be allowed to pierce the corporate veil simply because the business owing them debts is unable to pay. Creditors must demonstrate, by and through evidence, that the business acted in one of the 3 following manners:
- No True Separation Exists Between the Company and Its Owners
While corporations and LLCs are most often created with the specific intent of having an entity separate from that of the owner(s), this is not always the case. Instead, some businesses are formally created as a sham or what the court refers to as an “alter ego.” In this instance, the court determines that the owners have commingled assets so that the business’s affairs are not entirely distinct from that of an owner’s personal assets. This is commonly seen in instances whenever a business owner uses company funds in order to fund his or her personal expenditures such as vacations or purchases.
- The Business Acted Wrongfully or Fraudulently
Not all business practices are done with the best intentions. Sometimes, owners will act in a manner that is wrongful or fraudulent. These actions are done dishonestly and with knowledge that agreements could not be completed. For example, businesses could borrow money knowing that they will not be able to make partial or full repayment of the loan.
- Significant Undercapitalization
Personal liability may also extend in situations in which business owners failed to adequately fund the business. This is known as undercapitalization. Undercapitalization is a factor a court considers in determining whether to allow piercing of the corporate veil. This is because undercapitalization may indicate that a business is unable or unwilling to pay its debts, that owners are actively limiting a business’s liability through inadequate investments.
Courts Will Review Evidence to Determine Whether or Not to Pierce
It is important to remember that courts reach a determination on piercing the corporate veil after evaluating evidence. Courts will rely upon each state’s business laws and case precedent in order to reach a determination on piercing. Creditors will only be able to access the personal assets of owners and investors if the court determines that piercing the corporate veil is the appropriate remedy. Otherwise, the protections of limited liability remain intact.
Schedule a Consultation with Structure Law Group
If your business entity is facing the potential of having its corporate veil pierced, it is important that you seek the advice and counsel of a skilled business attorney. The Silicon Valley business attorneys at Structure Law Group have the knowledge and experience necessary to evaluate your business practices and safeguard you from exposure to personal liability for corporate debts. Contact Structure Law Group at 408-441-7500 today.