“Piercing seems to happen freakishly. Like lightning, it is rare, severe, and unprincipled.”
-Frank H. Easterbrook & Daniel R. Fischel, Limited Liability and the Corporation,
52 U. Chi. L.Rev. 89 (1985).
One of the primary benefits of distinct legal entity such as an LLC or corporation is that the entity incurs debts and other liabilities separately from its owner(s) whose personal assets are normally shielded from creditors. This shield is commonly referred to as the “corporate veil” shrouding the assets of shareholders from the debts of the corporation, though the same concepts now apply to the members of an LLC. Though a potent protection, this veil can also be pierced, allowing creditors to go after the owners of an entity directly. Though relatively rare, smaller, less well capitalized entities are at special risk, as are entities with a single controlling member or shareholder, making veil piercing of special concern to entrepreneurs.
1. OWNER(S) USED CORPORATION AS FACADE FOR PERSONAL DEALINGS AKA THE ALTER EGO THEORY: Both corporations and LLC’s have certain legal formalities that must be adhered to so as to maintain the distinction between the legal entities and their owners. Key among these is a prohibition on the commingling of personal and business funds. So, if a business owner uses business funds to pay for purely personal bills and expenditures, a court could find that the entity is simply operating as the owner’s alter ego, and that the owner should therefore be liable for the debts of the entity as the court would constructively treat the entity and the owner as one and the same.
Other considerations include the neglect of corporate minutes, absence or inaccuracy of corporate reports, or failure to file annual reports with the state Secretary of State’s office when required to do so.
2. THE ENTITY ENGAGED IN FRAUD OR OTHER WRONGFUL ACTS: If the entity engages in willfully defrauding customers, clients, or investors, or if the entity engages in reckless acts such as accepting deals that the owners of the entity know that they cannot perform on or pay the invoices for, the corporate veil may be pierced to prevent the entity from being used as a tool to enable such activity.
3. THE ENTITY WAS INSUFFICIENTLY CAPITALIZED: If the entity was never sufficiently capitalized to function independently of its owner(s), a court can rule that it was never a truly a distinct entity, and therefore deny limited liability protection.
Ultimately, the key thing to remember is that a distinct legal entity must actually be treated as a distinct legal entity. Think of your company as a “partner” that has its own income, its own debts, and its own property, and you won’t be far off. Just as you wouldn’t use your business partner’s credit card to buy yourself purely personal things, don’t use the business card, and just as you would keep track of loans or payments to your partner, keep proper track of any money or property that you put in, and take out of your entity, and have an attorney or CPA double check if you’re not sure. Finally, keep in mind that although the above guidelines are good rules of thumb, the ultimate arbiter of veil piercing doctrine is state law, so the actual rules vary state to state, so seek the advice of a local business attorney if in doubt as to whether you are about to engage in an act that may lead you to lose your protection.
ANTON LEONOV, is an Associate Trademark Attorney with LegalForce RAPC. From an early age, he has been experimenting with (others may call it “breaking”) computer hardware, in an effort to get the most out of every slice of silicon. Although his “just to see what happens” overclocking days are behind him, he is still a sucker for all things tech, and loves the opportunities that his IP legal career gives him to live at the crossroads of creation and the law. He holds a BA in Economics from UC Irvine, and a JD with honors from the Sandra Day O’Connor College of Law at Arizona State University. He is admitted to practice law in Arizona.
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