Piercing the corporate veil. What it is and how to avoid it.
Everything looked so rosy...
So, you've hired a lawyer, listened to her advice, and did exactly what she recommended.
You formed an LLC, put your company assets in it, and started doing business with the world as your LLC. Everything just looked rosy.
Then the lawsuit came - and you were personally named in addition to your LLC.
"No problem" you think. I've been doing business as an LLC so I can't be personally sued.
Well, not so fast.
Introducing MR. corporate veil
Before we go much further I'd like to introduce you to Mr. Corporate Veil. You really need to get to know him since he's one of your best friends.
You see, Mr. Corporate Veil is who steps in to protect you from your company's liability. If everything goes exactly as planned, then your company's liabilities only belong to the company and do not affect you. In fact, if you are sued for your company's liabilities (whether it be for your company's debts or alleged wrongdoings) then Mr. Corporate Veil springs into action and protects your personal assets from the lawsuit. If Mr. Corporate Veil is doing his job, then if you are personally named in a lawsuit against your company, then he can get the case against you thrown out of court pretty quickly and easily (yes, that's why you can't sue Tim Cook because the latest iPhone isn't up to snuff or sue Jeff Bezos if Alexa was calling you names - Mr. Corporate Veil protects them from their companies' actions).
If Mr. Corporate Veil is functioning right, he's pretty powerful and provides you and your personal assets with lots of legal protection.
The key phrase is "functioning right."
That's because there are many instances where courts will allow people to bypass Mr. Corporate Veil as if he wasn't even there and sue you directly for your company's liabilities. This is called "piercing the corporate veil" and is something that you will want to avoid at all costs.
What happens when the corporate veil is pierced?
If a court allows the corporate veil to be pierced, then you will personally be on the hook for your company's debts and liabilities.
This could come in two forms. Either you can be sued personally, along with your company, or a plaintiff could get a judgment against your company and collect it from you.
Either way, it is a very bad situation.
Luckily, with a bit of planning, you can keep Mr. Corporate Veil healthy and fully able to protect you from your company.
Best practices for a strong corporate veil:
- Form your LLC or corporation right. This means choosing the appropriate entity for your business and then doing things right all the way from filing with the appropriate government agencies to drafting the operating agreement (yes, every LLC needs one) or bylaws. Sure, it might seem easy to just pay a few dollars with an online outfit to get all this done, but sometimes (or maybe often) you get what you pay for.
- Have a well drafted operating agreement or bylaws and follow them. I can't emphasize enough how important it is to have an operating agreement (if you've got an LLC) or bylaws (if a corporation is your flavor of legal entity). These are the rules of the game that you are agreeing to follow in running your company. If your LLC or corporation doesn't even have rules, there's a very good chance your corporate veil won't be too sturdy.
- Capitalize appropriately. Capitalization is the money you give your LLC or corporation to start. There is no "right" amount here but keep in mind that the amount you capitalize your company with should be appropriate given it's business operations. If your capitalization is seen as being unreasonably low given the company's cash-flow needs, then that can be used as an argument to pierce your corporate veil. A $500 capitalization for a low overhead single-member consulting services LLC operated out of the home would probably be appropriate. That same amount would be nowhere near enough for opening a restaurant that has employees, a lease, and lots of inventory overhead.
- Don't share money. The courts call this "commingling funds" and it is probably the #1 reason they will let a corporate veil be pierced. Your LLC or corporation's money absolutely must be kept separate from your own. This means creating a separate bank account. This also means that all company revenues go into that bank account first and company expenses are paid directly by the company. If you want to distribute the money to yourself, great - after it gets deposited into the company bank account first. An additional step, yes, but a very important step.
- Maintain good records. Even though your company may have many legal rights of a human, it only exists on paper. That's why it's so important to make sure that you have all the right records to prove your LLC or corporation really does exist. For starters, there are legal requirements on what your LLC book or corporate book should contain at a minimum. Additionally, with a corporation you should be holding meetings and recording minutes to memorialize decisions that are being made (whether by officers, directors, or shareholders - depending on how your bylaws are written). Even though an LLC has much more relaxed rules on what records need to be kept, certain major decisions, like admitting a new member, electing a manager, or incurring significant debt, should all be memorialized in a resolution.
- Sign contracts the right way. Contracts definitely aren't the place to be shy about the fact that you are operating as an LLC or corporation. Whenever you are asked to sign a contract, whether it's as minor as a cell phone contract that costs $100 a month or as major as a lease that will cost you $4,500, it is absolutely critical that you sign in the name of your LLC or corporation. This means the contract should be between your LLC/corporation and the other party, and in the signature block, you aren't just signing as you - you should sign as "you, Member, XYZ, LLC" or "you, President, XYZ, Inc." Sometimes, especially if your company is new, has minimal history or revenue, and doesn't have credit yet, you might be asked to personally guarantee the contract. That's fine but the guarantee should not change the fact that you are signing the underlying contract on behalf of your company.
Minor details - big deal
These recommended best practices might seem like minor details. However, when you make it a habit to observe them (and make sure that your business partners and employees do too) it will become a big deal if the big, bad lawsuit ever comes along. These minor details, when taken as a whole, will enable Mr. Corporate Veil to swoop in and save the day.
Now, over to you. Are you comfortable with your business practices and how they protect you from liability? Do you agree or disagree with any of my suggestions? Interested in an evaluation of your business to see how well protected you are? Please feel free to share a comment or, if you're wanting more help, contact me for a free consultation!