Piercing The Corporate Veil—Why Business Formalities Are Important For Small Businesses

The legal term “piercing the corporate veil” describes a situation in which a court allows the people behind an LLC or corporation to face personal liability in lawsuits. While these types of business entities are often formed to protect the owners, shareholders, and board members from the risk of personal liability, there are some scenarios in which these individuals may be held personally liable, putting their own assets at risk. For this reason, all businesses should take preventative measures to ensure that their corporate veil is protected. For legal guidance on a wide range of business law matters, including the corporate veil, consider contacting an experienced business lawyer at Harrison Law, PLLC by calling (480) 320-2310 to schedule an evaluation of your case.

Limited Liability Protections Against Business Debts

The owners of small businesses often structure the business as a corporation or a limited liability company (LLC). These legal entities are completely separate from the individuals who form them. Many business owners choose one of these two structures to limit their personal liability in case the business becomes subject to lawsuits from creditors to recover debts or other issues. In most situations, this means that the owners of the business (along with shareholders and board members in corporations) cannot be held personally responsible to pay the debts of the business.

However, there are some scenarios in which a court will bypass the limited liability status of the LLC or corporation and hold individual owners or shareholders personally liable for the debts of the business. This more commonly occurs with small LLCs or closely held corporations (corporations with one owner or a handful of owners). Laws regarding piercing the corporate veil vary by state, but most courts are only willing to disregard limited liability protections in cases of serious misconduct by the people behind the company, according to the American Bar Association.

What Is Required To Pierce the Corporate Veil?

While courts generally respect the limited liability protections of LLCs and corporations, they are willing to disregard these protections if the circumstances call for it. According to the Arizona State Law Journal, a court may decide to pierce the corporate veil if all of the following circumstances apply:

• Wrongful or fraudulent actions by the business—The owners may be held personally liable if they recklessly borrowed and lost funds, entered into business deals knowing that they could not pay the invoices, or engaged in any other form of reckless or dishonest conduct that could constitute financial fraud
• No separation between owners and company—The court will evaluate whether there is a true separation between the company and its owners. If there is no formal legal division between the business and the personal finances of the owners, the court could deem the LLC or corporation invalid and allow its owners to face personal liability
• Creditors suffered unjust losses—If creditors that conducted business with the company have unpaid invoices or court judgments and either of the previous two circumstances applies, the court will address these unjust losses by piercing the corporate veil and allowing the creditors to sue the owners

You can learn more about the legal requirements for piercing the corporate veil from a skilled business lawyer at Harrison Law, PLLC.

What Factors Do Courts Consider in Piercing the Corporate Veil?

The determination of whether to pierce the corporate veil is based on many complex factors and specific circumstances related to the case. In addition to the previously mentioned requirements, courts will commonly consider the following factors when deciding whether piercing the corporate veil is warranted:

• Did the LLC or corporation commit fraudulent actions?
• Did the LLC or corporation fail to follow corporate formalities?
• Was the business inadequately funded? If the LLC or corporation never had sufficient operating funds, it was never truly a separate entity
• Was the LLC or corporation completely controlled by either one person or a small group of closely related people?

Are Small Businesses More Vulnerable to Corporate Veil Piercing?

Generally, small businesses are at a higher risk of facing personal liability due to their small size and business practices that often differ from those of larger corporations.

Failure To Adhere to Business Formalities

Smaller corporations and LLCs are less likely to adhere to corporate formalities, which opens them up to a higher risk of having their corporate veil pierced. These small business entities can take preventative measures to minimize this risk by complying with the following rules that govern the formation and maintenance of corporations:

• Hold annual meetings for directors and shareholders (or members)
• Maintain completely accurate and detailed records (known as “minutes” in the corporate world) for all important decisions made at the annual meetings
• Establish company bylaws
• Ensure that all officers and agents follow the bylaws

Higher Likelihood of Commingled Assets

Small business owners are more likely than large business owners to commingle personal assets and business assets. Examples of such behavior include writing a check from a company account to pay for a personal expense or depositing a check made payable to the business in the owner’s personal bank account. To avoid potential issues, the owners of small businesses should always keep their personal accounts and business accounts completely separate.

What Happens When a Court Pierces the Corporate Veil?

When a court decides to pierce the corporate veil, one or more of the company’s owners or shareholders will have their liability protection revoked. After this veil is removed, creditors have the right to file lawsuits and collect debts from the owners or shareholders who no longer have that protection.

At this stage, the personal assets of the owners—bank accounts, investments, real estate properties, and vehicles—will be made available to cover the debt. In some circumstances, the court may decide to only pierce the veil of one owner who is accused of wrongdoing, while preserving the limited liability for the innocent owners.

Learn More From an Arizona Business Attorney Today

Small business owners should be proactive and ensure that their companies are structured in a way that protects them from piercing the corporate veil. If you are ready to learn more about how to protect your personal assets and set your business up for success, consider contacting an experienced Arizona business attorney at Harrison Law, PLLC by calling (480) 320-2310 to schedule a consultation.

© 2022 Matthew W. Harrison and Harrison Law, PLLC All Rights Reserved

This website and article have been prepared by Harrison Law, PLLC for informational purposes only and does not, and is not intended to, constitute legal or financial advice. The information is not provided in the course of an attorney-client relationship and is not intended to substitute for legal advice from an attorney licensed in your jurisdiction.