What is the corporate veil? How can it protect me and what does it mean when it is pierced? We’ll cover these ideas critical to liability, wealth and asset protection.
What is the Corporate Veil?
By properly forming a corporation, LLC or Limited Partnership (LP) and taking the steps required for corporate formalities, a corporate veil is raised that may protect shareholders, officers and directors from personal liability and provide tax benefits. Creating a corporation, LLC, or LP establishes that entity (typically a company or real estate holding) as being separate from the owners. It is the ‘separateness’ of an entity which protects you – the entity’s owner – from unlimited personal liability. For example, without that separation, if an angry customer sues your company and wins, any assets you own such as your house, car or bank account can all be taken to cover the cost of the judgment found against you. However, to ensure that the corporate veil remains intact and business meets its potential, all persons involved in the corporation must follow certain corporate formalities. (While we refer to corporations in this article, the concepts and issues apply to LLCs and LPs as well. Don’t be misled by those who claim that the need for following formalities only applies to corporations.)
If you fail to follow the requirements of corporate formalities, you could be vulnerable to court decisions which pierce the corporate veil. Today, 50% of piercing the veil court cases succeed because owners are failing to properly follow corporate formality requirements.
Definition of Piercing the Corporate Veil
Definition: Piercing the Corporate Veil: A situation in which courts put aside limited liability and hold a corporation’s shareholders or directors personally liable for the corporation’s actions or debts. Veil piercing is most common in close corporations. While the law varies by state, generally courts have a strong presumption against piercing the corporate veil, and will only do so if there has been misconduct like abuse of the corporate form (e.g. intermingling of personal and corporate assets) or undercapatitalization at the time of incorporation. (Undercapatitalization would apply if the corporation never had enough funds to operate, and was not really a separate entity that could stand on its own).
If corporate formalities such as annual corporate filings and meeting minutes are not maintained in a timely and proper manner, courts can hold YOU, the entity’s owner, personally responsible for claims filed against the company. You need to keep your corporation filings current, and your legal protections intact.
How to Prevent Piercing the Corporate Veil
Limited liability and tax benefits are not a right granted to every business person, but privileges earned by following corporate formalities. The following nine rules provide general guidance for maintaining the corporate veil while conducting business through a corporation:
- Perform all annual filings;
- Maintain internal formalities, including having a resident agent in their state of formation and in any state the company qualifies to do business in;
- Maintain a written record of corporate decisions;
- Provide the world with corporate notice;
- Ensure the corporation is sufficiently capitalized;
- Maintain the distinction between corporate assets and personal assets;
- Use caution when distributing corporate profits;
- Separate bank accounts; and
- Separate tax returns
Although the burden of maintaining corporate formalities may not be appealing, the consequences of neglecting corporate formalities are great. Whether the corporation has followed the foregoing rules becomes important when a creditor seek to receive payment through the assets of the corporation’s individual shareholder, director or officer. Each rule and its various implications are discussed more in depth below.
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How to Raise the Corporate Veil
Once you have decided that a corporation, LLC or Limited Partnership (LP) is the right entity for your business or asset holding purpose and you have decided which state to incorporate in, corporate formalities begin. Events occurring immediately after formation must be performed properly to maintain the corporate veil and ensure the corporation’s longevity and flexibility.
A corporation is born when the Articles of Incorporation are properly filed. The corporate veil provided Shareholders with limited liability and is raised and maintained by management and ownership that treats the corporation like a corporation. As indicated above, a corporation is considered to be a legally distinct entity, capable of incurring its own debts and obligations. This protection is frequently referred to as the corporate veil. When creditors or others seek to obtain a judgement from a court that makes the corporations shareholders, directors or officers personally liable, they are seeking to pierce the corporate veil. This article will focus mostly on maintaining the corporate veil once it has been established, but briefly here are the requirements needed to set it up:
- File the Articles of Incorporation
- Hold organizational meetings to empower the corporation to conduct business and provide limited liability.
- Provide the corporation with competent initial management
- Issue the corporation’s shares of stock
Maintaining the Veil by Maintaining Corporate Formalities
Performing Annual Filings
Annual filings are required to protect and ensure the longevity of the corporation. In addition to the permits, licenses, or approvals that are unique to the corporation’s business, every corporation must obtain and maintain a corporate charter in good standing. In many states, a corporation must file an annual report, providing the names and addresses of Officers and Directors, and annual fees. If such filings are not completed in a timely fashion, the state may revoke the corporate charter and the corporation will cease to exist. The time, energy, and expense expended organizing the corporation will be wasted if the state revokes the corporate charter. While it may be possible to have the charter reinstated, the best way to maintain the corporate veil and ensure that the corporation serves its purpose is to simply perform annual filings in a timely manner.
Maintaining Internal Formalities
Bylaws adopted by the Directors in their organizational meeting provide the guidelines for the corporation’s future actions and corporate policy. Specifically, the Bylaws should provide the following:
1. Notice requirements for Directors meetings;
2. The minimum number of annual Directors meetings;
3. The date for annual Shareholders meetings;
4. The requirements for special Shareholders meetings;
5. The responsibilities of each Officer and Director; The procedures for removing Officers or Directors;
6. The procedures for Shareholders’ inspection of the corporation’s records; and
8. The name and address of the corporation’s resident agent.
Although they shape the internal operations of the corporation, Bylaws should not be complicated or provide intricate procedures. Necessity determines the extent and detail provided in the corporation’s Bylaws, which may be amended, altered, or repealed by the Board of Directors.
All decisions the corporation makes and all actions the corporation takes should be in compliance with the rules established by the Bylaws. Compliance with the Bylaws indicates that the corporation’s Directors, Officers, and Shareholders treat the corporation as a separate entity with its own rights and limitations. If the Directors, Officers, and Shareholders treat the corporation as a separate entity, courts will be less likely to ignore the division between corporate property and the rights of the individual Directors, Officers, and Shareholders. The corporate veil will be maintained.
As well, in most states it is imperative to have a current resident agent to accept service of process. Failure to have a resident agent in place can lead to arguments that the corporate veil should be pierced.
Maintain a Written Record of Corporate Decisions
Even if a small group of people or a single person controls the corporation, it should conduct meetings and prepare records of such meetings. Shareholders and Directors conduct three types of meetings, which should each be recorded through minutes of meetings. As provided above, immediately following incorporation, organizational meetings should be conducted. During the corporation’s life, regular meetings must be conducted annually pursuant to the corporation’s Bylaws to reflect elections and the corporation’s other decisions. Additionally, a corporation may hold special meetings when called by the Directors or Shareholders. Special meetings are held to discuss urgent items of business or to approve any legal or tax issues. The general procedure for conducting Directors or Shareholders meetings is provided below.
Prior to a meeting of Shareholders, all Shareholders must receive or waive notice of the meeting. Prior to a Directors’ meeting, all Directors must receive or waive notice of the meeting. In meetings of Shareholders or Directors, corporate formalities require voting and an official record of actions taken at the meeting. The official record of actions taken in regular meetings, as well as the organizational meetings, is provided as the minutes of the meeting. Minutes provide a record of the corporation’s resolutions. A resolution is a document that records actions that the Directors or Shareholders “resolve” to take on the corporation’s behalf. The nature and timing of the corporation’s decisions dictate whether a resolution or minutes of a meeting provide an appropriate record of a decision.
An alternative in most states to conducting actual meetings and preparing minutes for those meetings is for the corporation to authorize action by written consent. This is the quickest and easiest way to document formal corporate action. Directors and/or Shareholders sign a document that contains the language of the corporation’s decision or resolution. By signing the document, the Directors and/or Shareholders approve the decision or resolution. To ensure that an action by written consent is adequately documented, all Directors and/or Shareholders must sign the consent form. The corporation should keep signed consent forms in the corporate minute book.
By conducting the necessary meetings and preparing adequate records, a corporation provides documentation to protect the corporate veil. Should a creditor seek to pierce the corporate veil at a later date, the corporation’s records will serve as evidence of its separate existence. In addition, maintaining proper records may help to avoid future miscommunications and misunderstandings within the corporation.
Although many people believe that preparing annual meeting minutes is difficult, the minor inconvenience is greatly outweighed by the potential problems that failing to prepare such records could cause. If necessary, a service provider may prepare the required minutes for the corporation for a reasonable fee. Our firm charges $150 per year to prepare minutes. You may call toll free 1-800-700-1430 for more information.
Providing the World with Corporate Notice
Whenever the corporation enters into a contract or engages in any business activity whatsoever, it must do so clearly as a corporation. Individual Officers or Directors may be subject to personal liability if they act on the corporation’s behalf, but fail to clearly indicate that they are acting in their capacity as the corporation’s Officer or Director. To avoid creditors or others from piercing the corporate veil and attacking individual members of the corporation’s management or Shareholders, it must be clear that the corporation, and not an individual, is acting. Business cards, letterhead, invoices, company checks, brochures, etc … must identify the corporation. The full name of the corporation should be provided (not XYZ, but XYZ, Inc.). All contracts and correspondences signed by Directors or Officers for the corporation should be signed with reference to their corporate designation. If the corporation takes steps to ensure that others know that the corporation, and not an individual Officer or Director is acting, the corporate veil will be more resistant to attack.
Although most jurisdictions will not allow creditors to pierce the corporate veil solely because the corporation had insufficient assets, the risk of veil piercing provides reason to ensure that the corporation is sufficiently capitalized. California and few other states have relied on under¬capitalization in piercing corporate veils. A corporation should have sufficient resources to meet its short-term obligations whether it is just starting, is part of a cooperative project, or is merely one element in a greater corporate strategy. If the corporation is undercapitalized, a creditor may argue, and a court could accept the argument, that the corporation exists simply to help its owners shelter their assets. As is discussed further below, this may be enough reason for a court to pierce the corporate veil and find personal liability for Officers, Directors, and/or Shareholders.
Maintaining the Distinction between Corporate and Personal Assets
A common but fatal mistake for developing corporations occurs when its management and/or Shareholders fail to maintain the distinction between corporate and personal assets. Whether arising from loans from the corporation to individuals, shared bank accounts, shared tax returns, or individual use of corporation property, failure to separate corporate assets from personal assets negates the corporation’s separate identity. To prevent creditors from piercing the corporate veil, the corporation must maintain a separate bank account, file separate tax returns, and use corporate assets only for corporate purposes.
The corporation should not be used as a lender for its Officers, Directors or Shareholders. An air of impropriety is created when a corporation loans money to members of management, even if management genuinely intends to repay the loan. The infamous chain of corporate scandals in spring and summer 2002 highlighted the dangers involved in loaning to management, as such loans were often cited in allegations that a Director or Officer breached their fiduciary duties. The best way for the corporation to avoid potential problems is to refuse to lend money to its Directors and Officers.
Regardless of their personal interest or role in the corporation, nobody should treat the corporation’s property as personal property. By clearly distinguishing between corporate and personal assets, the corporation may indicate and retain its separate identity. By reporting and maintaining the corporate assets separately from management’s or Shareholders’ personal assets, the corporation will reduce the potential for successful lawsuits against Officers, Directors, and individual Shareholders.
Cautiously Distributing Corporate Profits
Whether a corporation distributes its profits through dividends paid to shareholders or compensation paid to employees, the corporation’s distribution of profits may provide a basis for creditors to pierce the corporate veil. The veil that limits the liability of Shareholders, Directors, and Officers also creates limitations on the corporation’s ability to pay such corporate actors from the corporation’s profits. If the corporation fails to obey established rules for the distribution of corporate profits, a creditor may use such failure as an indication that the corporate actors are not treating the corporation as a separate legal entity. To reduce creditors’ ability to pierce the corporate veil, the corporation must exercise caution in distributing its profits.
Every state authorizes a corporation’s Board of Directors to issue dividends to its Shareholders. However, the Directors’ decision to declare dividends may result in substantial fines assessed against the individual Directors if the dividend is found to be illegal. Dividends from surplus cannot exceed limits established by reference to the corporation’s assets. “Nimble” dividends, or dividends paid from profits, may be issued when the corporation’s surplus is insufficient. However, such dividends may only be paid when such payment does not impair the capital representing preferred stock. Directors must determine whether the corporation has sufficient funds legally available to pay dividends to protect themselves from potential liability. To avoid liability arising from the issuance of dividends, corporations should consult with legal counsel before deciding to issue dividends.
Separate Bank Account
A corporate veil will be pierced in cases where the company founders use a personal bank account for business affairs. You cannot consistently pay business expenses from a personal account and, conversely, you cannot pay personal expenses from a company bank account. Failure to follow these simple guidelines can be catastrophic, so as soon as you incorporate obtain an EIN (Employer Identification Number) from the IRS and use it to open a corporate bank account.
Separate Tax Return
Because you have obtained an EIN for your entity you must now file a separate tax return with the IRS. Fear not, this is your chance to take all the deductions you may be entitled to take. But failure to file a separate return can lead to claims that you are not following corporate formalities. So file – and take advantage of the tax benefits you are entitled to in the first place.
Many developing corporations do not have sufficient assets or profits to distribute dividends to Shareholders, but they must compensate Officers, Directors, or other employees for their services. Especially in start-up businesses, the compensation a corporation pays to Officers, Directors, and other employees may determine the corporation’s ability to succeed. Equity compensation (using shares of the corporation’s stock, stock options, or other alternative forms of compensation) may be attractive. Compensation based in part on the corporation’s profits may also be appealing. However, all forms of compensation should be based primarily upon the market value of the employee’s services. The Internal Revenue Service may scrutinize excessive compensation paid to Directors, Officers, or employees and decide to tax excessive compensation as dividends.
Corporations that over-compensate their employees may create liability for the Directors based on Shareholders’ claims of mismanagement, breach of fiduciary duties, self-dealing, or waste of corporate assets. Through a derivative action, the Shareholders may regain control of the corporation and its assets. The corporation may then assert legal claims against former Directors, creating personal liability for such Directors. To avoid potential liability based on employee compensation and excessive tax liability, Directors must ensure that compensation paid by the corporation is reasonable.
All decisions regarding the distribution of a corporation’s profits or compensation for employees is subject to the discretion of the Board of Directors. However, to avoid potential liability for the corporation and for themselves, Directors must carefully consider the effects of every use of the corporation’s assets. Caution and the advice of legal counsel may be necessary to prevent the Board’s distribution decisions from creating unwanted liability.
Some states are more likely to pierce the corporate veil than others. As well, in some states veild piercing cases are brought more often. The top five states in order of most cases filed are:
- New York,
- Ohio and
As you would expect, the filings reflect population density. But they also reflect the states in which the strategy may be successful. On a national basis 50% of veil piercing cases were successful, which is all the more reason to be cautious when dealing with corporate formalities.