Limitations of Corporate Forms: Piercing the Veil

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What is the corporate veil?

There are many benefits to becoming a corporation. From credibility and access to capital, to corporate tax advantages and the protection of limited liability, the advantages of incorporating a business typically outweigh the disadvantages. The lure of limited liability for shareholders and owners is one of the most touted of these advantages. Limited liability through incorporation creates a fictional shield between the assets of the owners and the corporation. This shield is often called the corporate veil.

What does “piercing the corporate veil” mean?

Usually, through limited liability, a corporation is treated as a separate person in legal situations, which means the corporation is held responsible for its actions, but the shareholders are not personally liable for these actions. They are protected by the corporate veil. However, if a court of law is given reason to investigate the liability of a corporation’s owners or shareholders, then it is considered “piercing the corporate veil”. The owners and/or shareholders no longer have the protection of the corporate shield and can be found personally liable in a court of law.

Reasons to Pierce the Corporate Veil

There are many reason to pierce the corporate veil and expose owners, shareholders, or board members to personal liability of the corporation’s activities. In the article, The Five Most Common Ways to Pierce the Corporate Veil and Impose Personal Liability for Corporate Debts Debts, there are particular factors that raise red flags more than others:

    1. The existence of fraud, wrongdoing, or injustice to third parties.
    2. Failure to maintain the separate entities of the companies.
    3. Failure to maintain separate identities of the company and its owners or shareholders.
    4. Failure to adequately capitalize the company.
    5. Failure to follow corporate formalities (Jimmerson & Snell, 2016)

These presenting factors, among many others, could induce the court to pierce the corporate veil. However, there are strict rules for doing so, but the ruling is based on common law precedents in the jurisdiction of the corporation’s home state (Lahm & Geho, 2007).

Preventing Issues with the Corporate Veil in Small Business

According to Robert B. Thompson (1991) in Piercing the Corporate Veil: An Empirical Study “corporate veil piercing is the most litigated issue in corporate law” and yet, Wikipedia claims (without reference) that “there is no record of a successful piercing of the corporate veil for a publicly traded corporation” (Piercing the Corporate Veil, n.d.).  Most large corporations will settle before they risk piercing their corporate veil. Given this information is accurate, it would be safe to assume that the majority of litigation involving corporate veil piercing occurs at the small business level.

In Lahm and Geho’s paper (2007), Holes in the Corporate Veil: Confronting the Myth of Reduced Liability for Small Business and Entrepreneurs Under Corporate Forms, the authors address the paucity of academic literature on corporate veil piercing and the failure to convey to students of entrepreneurship and small business owners that there are already holes in the corporate veil.

“Using a corporate form ordinarily will insulate the owners from direct liability for the company’s obligations, because the corporation is considered to be a separate legal identity, independent of its owners” (Peckinpaugh, 2000). However, and this is a significant “however” often omitted in form or substantive discussions within textbooks, the scholarly literature of entrepreneurship, and in popular press outlets: this shield can only be effective if certain conditions are met. These conditions vary somewhat from state to state, and courts have interpreted cases based on what typically entails extensive examination of whether or not veil piercing is a justifiable remedy” (Lahm & Geho, 2007).

It is important for the small business owners to take steps to ensure the strength of their corporate veil. They should not give the courts a reason to pierce the veil. “Taking the proper steps to insulate personal liability could make the difference between the effective creation of a corporate structure versus the daunting effects of personal liability” (Jimmerson & Snell, 2016).

Based on, The Five Most Common Ways to Pierce the Corporate Veil and Impose Personal Liability for Corporate Debts, a small business should pay attention to the rules of the corporate structure that upholds the veil.

1.Practice transparency. Operate your business with integrity, both in finances and in customer relations. If your company’s activity “appears to be fraudulent or even just questionable, the company should consult legal counsel to guide it through its decision-making process (Jimmerson & Snell, 2016).

2. Maintaining the identity of your company from that of its subsidiaries or affiliates is imperative to keeping a strong corporate veil. If your parent company has the same contact information, officers, or tax filing as the subsidiary, the court will consider it an “alter ego” of the parent company rather than a separate entity.

3. The owner and/ or shareholders must also maintain a separate identity from the company. For example, don’t use the company credit card to fund your family vacation, or borrow money for the business with your home as collateral.

4. Make sure your company has adequate capital to account for business operations in its own separate bank account. “Courts will look to the assets of the company to determine if the company’s level of assets to creditors is fair” (Jimmerson & Snell, 2016).

5. Follow the formalities required of the corporate structure. Each type of business structure has formal rules and regulations that must be followed. Stay on top of state and federal filings, keep stockholders updated on their investments, keep accurate records, and generally maintain a tight ship.

And finally, when in doubt seek professional counsel from a corporate attorney. Entrepreneurs and small business owners may not be guilty of breaking laws by deceit, but by lack of information or resources to maintain proper boundaries between themselves and their corporation.

 

References

Jimmerson, Charles B. & Snell, Brittany N. (2016, March). The Five Most Common Ways to Pierce the Corporate Veil and Impose Personal Liability for Corporate Debts. [Jimmerson & Cobb P.A.] Retrieved from https://www.lexology.com/library/detail.aspx?g=4ff8ebf0-4bca-426e-8273-758140f6d0eb

Lahm, Robert J. & Geho, Patrick R. (2007). Holes in the Corporate Veil: Confronting the Myth of Reduced Liability for Small Businesses and Entrepreneurs Under Corporate Forms. The Entrepreneurial Executive, Volume 12.65-81.

Peckinpaugh, C. (2000). Behind the corporate veil. Federal Computer Week, 14(23), 78.

Piercing the Corporate Veil (n.d.) Retrieved From https://en.wikipedia.org/wiki/Piercing_the_corporate_veil

Thompson, Robert B. (1991). Piercing the Corporate Veil: An Empirical Study. Cornell Law Review76: 1036–1074.

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