Once you have your business organized, you are still not completely immune from personal liability. When the courts hold individuals accountable for the actions of the corporation, this is known in legal parlance as “pricking the corporate veil.” To avoid personal liability for debts and other acts of the corporation (or LLC), you must manage your business entity as a truly distinct entity and separate from the personal affairs of each owner.
The corporate shield cannot be simply a facade without a real business purpose and the business must display characteristics that resemble a real and ongoing business. In closely held corporations (very few shareholders), the same individuals tend to act in several different capacities, and this requires an effort to maintain those distinctions. Not to mention, small business owners naturally tend to treat all income as personal income and use business assets for personal use.
Courts normally look to see if there are “a unit of interest and ownership such that the separate personalities of the entity and the owner no longer exist and to maintain the distinction between the owner and the entity would be an injustice.” In other words, if the corporation or LLC is the alter ego of the individual and they recognize that the distinction would be unfair or fraudulent, the veil will be pierced. It is impossible to describe everything you need to do to prevent the corporation or LLC from being seen as a mere extension of the owner. However, it is important enough that you must have a basic understanding of the dos and don’ts to help insulate yourself from personal liability.
A member of an LLC or shareholder of a corporation can be held personally liable for many different types of claims, but they generally arise under these different scenarios:
1. Claims arising from an act or omission of the owner directly, such as negligence, fraud, illegal act or violation of a fiduciary duty of the owner;
two. Claims arising out of a contract, particularly one that was personally guaranteed by the member;
3. Liability for unpaid labor taxes, wages, workers’ compensation insurance, and unemployment contributions;
Four. Claims based on the LLC’s “piercing the veil” concept;
5. Liability for consenting to or receiving a distribution in violation of the LLC’s operating agreement or applicable LLC statute.
These statements are not the result of choosing an LLC over a corporation, or vice versa. All of these exceptions apply equally to corporate shareholders and LLC members. But there are many exceptions to the limited liability rule. Many LLC members or shareholders will find that because of the way the business was operated, the promised protection against business liabilities and claims is not significant.
Important factors used to pierce the veil
The courts will generally determine whether you or the other owners have conducted the business as a separate and distinct entity, and not as the owners’ alter ego, as noted. But what actions or non-actions of the owners prove it in the eyes of the courts? State courts will analyze all the separate facts and circumstances of each case to determine whether or not the corporate veil is breached. There are some common factors that show to a court that your business was established as a sham or was an extension of yourself. Undercapitalization, where it is clearly shown, is an important factor. But, it is not an absolute reason to pierce the corporate veil on its own without other existing factors.
These are the most common and key factors considered by the courts in determining whether to pierce the corporate veil:
1. If the corporation complies with the corporate formalities (That is, create and follow the requirements and procedures established in the bylaws, keep minutes of shareholders and board of directors meetings and prepare agreements for important actions of the company);
2. Absence of corporate records;
3. Inadequate capitalization. The corporation is undercapitalized at the time the transactions are entered with creditors or others who want the corporate veil to be broken, or there is simply not enough capitalization for the particular corporation to function. State laws govern the formation of a corporation. Inevitably, these laws establish amounts or formulas to determine the minimum amount of capitalization required for a corporation. You should check the laws in your state to determine the amount and make sure you meet the contribution minimums. In short, the lack of capitalization means that the corporation was never a viable entity because it did not have sufficient funds to support the debt obligations;
4. If the major shareholders are using money from the corporation for their personal use. (That is, when shareholders take money from the corporation to pay their personal bills or buy gifts for themselves, etc.) or when they use other assets for personal use or gain;
5. Lack of functioning of other officers or directors (have officers and directors who do nothing and were appointed by a majority shareholder, but who are not actively involved in directing the business and affairs of the corporation);
6. Mix of funds and other assets between the principal shareholders and the corporation (or LLC);
7. No corporate assets of any kind;
8. Use of corporation to transfer responsibility of another (usually a shareholder);
9. No issue of shares and no payment of dividends.;
10. Not keeping track of gross income and expenses.;
11. Contract with another without the intention of complying with the obligations.;
12. Do not maintain independent transactions with third parties.
These are not the only factors that the courts have considered, just some of the most common and the ones that you absolutely must follow at all times.
Piercing the corporate veil of LLCs
Generally, a member or manager is not personally liable for the LLC’s debts, obligations, or liability solely by virtue of being or acting as a member or manager. However, the concept of piercing the corporate veil applies to LLCs and the courts can and have allowed LLC members to be personally liable in some cases. Some states, including Minnesota and Colorado, have adopted statutes that specifically apply the concept of shifting the corporate veil to LLCs. In other jurisdictions, such as Connecticut, Louisiana, Georgia, California, etc., it is the courts that have generally applied the concept of shifting the corporate veil to LLCs through case decisions.
Despite what you hear about LLCs, the The members will be personally liable if the corporate veil of the LLC is transferred by a similar court to the shareholders. Courts will apply the same general alter ego analysis that is used to pierce corporations, but sometimes without taking into account the lack of corporate formalities. While some corporate formalities do not have to be followed under the LLC’s organizational bylaws, this does not give LLC members carte blanche to operate as they please and avoid personal liability. For example, annual meetings are not required under most LLC state statutes, nor are there detailed notification requirements for meetings and elections. However, certain corporate formalities common to both entities must be followed; LLC owners operating an Internet business should follow the same basic guidelines that corporations should follow.
Actions of an owner as a director, officer or manager
Shareholders, officers, directors, and members of an LLC are always personally liable for their individual criminal acts. They are also always personally liable for their own direct acts or omissions that result in damage to persons or property (ie, torts), even when those acts were performed in the course of the company’s business. For example, if you are an electrician and you leave a faulty wire exposed, the fact that you have formed an LLC will not protect you from this negligence.
Similarly, if you drive the company vehicle and injure someone on your way to a business meeting, You are still forever personally responsible for your own personal actions. To the extent that you direct or authorize in your capacity as director, officer or manager an action that is or results in a criminal act or causes damage to people or property, you can be held personally responsible. Any member who is actively involved in the business of the LLC or corporation runs the risk that their action or inaction will result in personal liability. This is particularly a risk of a service business in which the members provide the key service. In the example I used earlier, if you are an electrician and you leave an exposed wire that electrocutes someone, your LLC will not protect you. The same happens if you are a shareholder.
If you make promises about your product or service that are not true, there may be a claim against the entity for breach of contract. However, if the LLC is unable to perform or pay the damages, the injured party can pursue it for fraud or a similar claim based on their own action. Even if you have an employee who committed the action, you may not be out of the woods. If you personally hired the employee, the injured party may have a claim against you for negligent hiring if a reasonable person had not hired that employee.