"Piercing the corporate veil" is a legal phrase that describes the owners of a corporation losing the limited liability that having a corporation provides them. When this happens, the owners’ personal assets can be used to satisfy business debts and liabilities. This concept doesn’t apply only to corporations, however. Any business type that provides limited liability to its owners is at risk of piercing the corporate veil if the owners don’t take the steps necessary to ensure this protection remains intact.
Protecting your assets
Corporations and limited liability companies (LLCs) exist separately from their owners. Because of that, business assets are separate from owner assets. One of the main reasons you’re probably considering incorporating your business or forming an LLC is for the personal asset protection these business types provide. This protection is not guaranteed however. There are responsibilities that come with it.
5 steps for maintaining personal asset protection and avoiding piercing the corporate veil
Owners of corporations and LLCs must take steps to show that the business exists separately from the owners. Key steps include:
- Undertaking necessary formalities. Corporations have strict formalities they must follow, and while LLCs do not face the same requirements, many of the same steps are advisable.
- Corporations. Create and regularly update bylaws, issue shares of stock to owners (shareholders) and maintain a stock transfer ledger, hold both an initial and then annual meetings of both directors and shareholders, undertake any annual filings required by the state of incorporation in a timely manner and pay the necessary filing fees, and pay corporate taxes.
- LLCs. Undertake any annual filings required by the state of incorporation in a timely manner and pay the necessary filing fees. Recommended formalities include creating and regularly updating an operating agreement, issuing membership certificates to owners, keeping a membership transfer ledger, and holding both initial and annual meetings of the members (and managers, if your LLC is manager-managed).
- Documenting your business actions. Document the major business decisions and the major meetings you hold. For example, sign and keep contracts your company enters. Document that you held the initial and annual meetings of directors and shareholders (corporations) or members/managers (LLCs) and keep the meeting minutes from each of these meetings. Keep formal business documents for at least seven years.
- Don’t comingle business and personal assets. Keep business assets separate from the assets of the owner(s). Have a business checking account and business credit card and only use these for business expenses. Also keep assets such as equipment and property separate.
- Ensure adequate business capitalization. Your business will need money and the equipment and items necessary both to start and continue operations. There are many ways to do this: through your own money, accepting money from others and making them business owners, or through a business loan. Whatever your approach, without adequate capital, your business will not survive. Keep in mind, this capital needs to be designated to your business and not to you.
- Make your corporate or LLC status known. Create business cards that display the name of your corporation and LLC. Make purchases and pay invoices via a business checking account or credit card. Create invoices in the company name to send to your clients. Also, any contracts, leases and/or documents you sign should be in the company name.
Remember: if a judge cannot distinguish between what belongs to the business and what belongs to the owner—and the owners cannot provide proof that all formalities have been followed—it may be deemed that you’re acting more like a sole proprietorship or general partnership than a corporation or LLC. The judge can then "pierce the corporate veil" and award your personal assets to any plaintiff.