A key reason that business owners and managers choose to form a corporation or limited liability company (LLC) is so that they won't be held personally liable for debts should the business be unable to pay its creditors. But sometimes courts will hold an LLC or corporation's owners, members, and shareholders personally liable for business debts. When this happens it's called "piercing the corporate veil."
In these tough economic times, many small business owners are scrambling to keep their companies afloat or are closing down. If a corporation or LLC ends up having to shut its doors, the last thing a small business owner wants is to have to pay the business's debts. But when cash is tight and owners aren't careful, if an unpaid creditor sues for payment a court might "pierce the corporate veil" (lift the corporation or LLC's veil of limited liability) and hold the owners personally liable for their company's business debts.
Read on to learn the rules about piercing the corporate veil. (To learn about other ways you can become personally liable for corporate debt, see Nolo's article Are You Personally Liable for Your Business's Debts?)
Corporations and LLCs are legal entities, separate and distinct from the people who create and own them (these people are called corporate shareholders or LLC members). One of the principal advantages of forming a corporation or an LLC is that, because the corporation or LLC is considered a separate entity (unlike partnerships and sole proprietorships), the owners and managers have limited personal liability for the company's debts. This means that the people who own and run the corporation or LLC cannot usually be held personally responsible for the debts of the business. But, in certain situations, courts can ignore the limited liability status of a corporation or LLC and hold its officers, directors, and shareholders or members personally liable for its debts. When this happens, it is called piercing the corporate veil. Closely held corporations and small LLCs are most likely to get their veils pierced (corporations that are owned by one or just a few people are called closely held corporations, or close corporations for short).
If a court pierces a company's corporate veil, the owners, shareholders, or members of a corporation or LLC can be held personally liable for corporate debts. This means creditors can go after the owners' home, bank account, investments, and other assets to satisfy the corporate debt. But courts will impose personal liability only on those individuals who are responsible for the corporation or LLC's wrongful or fraudulent actions; they won't hold innocent parties personally liable for company debts.
Courts might pierce the corporate veil and impose personal liability on officers, directors, shareholders, or members when all of the following are true.
The most common factors that courts consider in determining whether to pierce the corporate veil are:
Some corporations and LLCs are especially vulnerable when these factors are considered, simply because of their size and business practices. Closely held companies are more susceptible to losing limited liability status than large, publicly traded corporations. There are several reasons for this.
Failure to follow corporate formalities. Small corporations are less likely than their larger counterparts to observe corporate formalities, which makes them more vulnerable to a piercing of their corporate veil. To avoid trouble, it's best to play it safe. It's important for small corporations and LLCs to comply with the rules governing formation and maintenance of a corporation, including:
Commingling assets. Small business owners may be more likely than their larger counterparts to commingle their personal assets with those of the corporation or LLC. For example, some small business owners divert corporate assets for their own personal use by writing a check from the company account to make a payment on a personal mortgage -- or by depositing a check made payable to the corporation into the owner's personal bank account. This is called "commingling of assets." To avoid trouble, the corporation should maintain its own bank account and the owner should never use the company account for personal use or deposit checks payable to the company in a personal account.
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