Piercing the Corporate Veil
A big concern for small business owners is (and if not, it should be) piercing the corporate veil. One of the main reasons for forming a business as a corporation or limited liability company (LLC) is to protect the personal assets of the business owners. In a corporation or LLC, the owners typically will not be personally liable for the debts or obligations of the company. However, in some situations, a court will determine that the owners of a business should be personally liable for the debts of the company. This is called “piercing the corporate veil.” When a court pierces the corporate veil, the business owner’s home, bank accounts, investments, and other assets may be tapped to satisfy the debts of the company.
So when would a court determine that it is appropriate to pierce the corporate veil of a corporation or LLC? The answer lies in a three-prong test that a court will apply:
- First, the court will look at the facts of the case to see if the company is the “alter ego” of the business owner. More on that in a minute.
- Second, the court will consider if the business owners are using the limited liability of the company to defraud or evade the otherwise legitimate claims of creditors. If the company borrowed money that the owner knew it probably wouldn’t be able to pay back or made business deals knowing that the company probably didn’t have enough money to pay for, that will be an indicator to the court that piercing the corporate veil may be appropriate.
- Third, if it would be “unequitable,” or in other words unfair, to let the business owner get away with not paying its creditors, the court will be more inclined to pierce the corporate veil and hold the owner personally liable.
Let’s expand on the “alter ego” thing I mentioned. There are eight factors that a court will consider to determine if the corporation or LLC is really just the alter ego of the business owner:
- The company is operated as a distinct business entity;
- Commingling of funds and assets;
- Inadequate record keeping;
- The nature & form of ownership facilitates fraud or misuse by the owners—this makes it especially risky for single-member LLCs. Since there is only one owner, it would be easy for the owner to misuse the business since there is nobody else around to hold him or her accountable;
- Inadequate capitalization;
- The company is a “mere shell”;
- The business owners disregarded corporate formalities such as adopting and following by-laws or operating agreements; and
- The assets and/or funds of the company were used for non-company purposes.
The court will do a balancing test of the eight factors to determine if the company is an alter ego of the business owners. That means that not all eight factors must be present, and no one factor is more important than the others.
When set up and run correctly, a corporation or LLC can be a great way to shield a business owner’s personal assets from the debts and liabilities of the company. But if that presumed liability protection is abused or taken advantage of, a business owner can quickly find himself in a whole heap of personal trouble.
Denver, Colorado business attorney Aiden H. Kramer can counsel you on piercing the corporate veil and can assist you in ensuring that your personal assets are protected. Contact Aiden Kramer today at (720) 379-3425 or [email protected] to discuss the best way to go about setting up and running your business.