What Is Corporate Veil and When Is It Pierced?
Corporate Veil is a legal term to describe the protections that business owners have from the liabilities of their business. Generally speaking, the personal assets of owners for limited liability companies and corporations are immune from contractual debts and lawsuits that may arise out of business operations. For example, the personal property of a LLC business owner cannot be seized for non-payment of dues to a creditor.
When courts or debtors hold businesses accountable for their liability, then they are said to be “piercing the corporate veil.” Such occurrences, where corporate veils are pierced, are the exception rather than the norm. But courts have sanctioned them in cases of egregious fraud and law-breaking by corporations and organizations.
What is a Corporate Veil?
Limited liability is a cornerstone of corporate law because it prevents a firm’s creditors from holding its shareholders and officers responsible for losses or liabilities that the firm may incur. In turn, this principle reduces the accompanying risk in a business and enables company founders to access liquidity from public and private markets.
The concept of corporate veil derives from the limited liability principle because it separates the corporation, i.e., the entity, from its shareholders, employees, and officers. It assigns a “personhood” to the corporation that is distinct from that of its officers, meaning creditors cannot sue employees and officers of a corporation for liabilities and losses. The corporate veil also allows a company’s employees and a firm’s officers to take advantage of governmental benefits, such as unemployment insurance, in case of bankruptcy or adverse circumstances. If the corporate veil did not exist, then they would be held accountable for corporate losses and would lose eligibility for such benefits.
When Is a Corporate Veil Pierced?
Limited liability does not completely let corporations off the hook. Examples of instances in which a court may intervene to pierce a corporate veil are:
- If a business does not follow applicable rules and maintain its business in good standing with the state where it is incorporated. For example, it may not have filed for incorporation in the state it operates or it may have provided insufficient or incorrect information during the process of incorporation.
- If a business does not keep sufficient capital to maintain solvency of its operations. While there are no minimum capital requirements by law, businesses should have sufficient funds to meet their tax obligations and operational expenses.
- If a business does not separate corporate identity, or the identity of business as a legal person, from its owner’s identity. An example of this is a business owner mixing personal and corporate identity by using company funds for personal expenses.
- If a business takes advantage of the corporate veil to defraud its shareholders and customers. For example, senior executives within a business may orchestrate their operations and accounting to show profits when there are none in order to raise funding from investors. There may also be the case that a business may not exist in reality in spite of receiving funding from investors. Or it may not make its dividend payouts or distributions to shareholders despite generating profits.
One of the most famous cases involving piercing of corporate veils was that of Enron, an oil major that falsified its accounting to show profits. After the company filed for the largest corporate bankruptcy in US history in 2001, its accounting books were investigated and company officers were held liable for enriching themselves at the expense of shareholders and creditors.
Legal Standing of Corporate Veils
In general, courts have taken a conservative approach to piercing the corporate veil. Resolution of such cases is on a case-by-case basis rather than on the basis of statutory law, leading to a diverse set of judgements that depend on differing interpretations of corporate law in states.
Researchers and lawyers have particularly noted the open-ended language used in such judgements. An example is the concept of “alter ego” which has often been used in rulings convicting or defending parties against corporate veils. There is not much explanation or clarity about the factors being considered while assigning corporations the identity of an individual’s alter ego. According to legal scholars, courts have ruled for or against piercing of the corporate veil using the same concept, leading to confusion among corporations regarding its applicability.
Regulation concerning corporate veils differs between states. For example, Florida requires prosecutors to show either that the relevant corporation is an “alter ego” of a parent corporation or that the alleged parent company also engaged in improper conduct in order to pierce the corporate veil. Nevada has more stringent conditions in the form of a three-part test to establish the “alter ego” condition.
By virtue of its standing as a commercial and financial center, New York has the maximum number of piercing cases. In contrast, Delaware and Texas have fewer cases because they have stricter conditions to allow courts to peek inside a corporate veil.
How Can You Maintain Corporate Veil Protection?
There are several steps that you can take to ensure that your company does not run afoul of corporate law. Here are some of them:
- Separate personal and business spending: Most cases in which corporate veils are pierced involve ones in which the owner(s) may have spent funds meant for the business for their personal use or for illegitimate purposes. This is known as “commingling” of funds and is considered a serious offense. Having separate bank accounts and accounting for personal and business use is good hygiene and will help discipline your expenses on both fronts.
- Ensure that you have the necessary documentation: Running a business requires extensive documentation to prove that you have the necessary legal permissions to operate in a given jurisdiction. These run the gamut from articles of incorporation to business licenses and permits. Make sure that you have applied to or have been approved for these licenses.
- Stay updated on statutory requirements: As mentioned earlier, resolution of cases involving corporate veils generally occurs on a case-by-case basis that is mostly dependent on state laws and requirements for operating a business. If you have a business that spans multiple jurisdictions, then you may be liable for staying in line with multiple legal requisites.
Be On Top of Your Game
Embarking on any business entails business owners to be always on top of their game. From smart marketing strategies to careful and comprehensive financial plans, every business owner has to be fully geared up. Team up with a financial advisor in Greenville, SC today and discuss how you can be more effective in your business. If you don’t live locally, please feel free to check out our financial advisor page to see one you can connect with.
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About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.