One of the biggest advantages to incorporating a business is that the shareholders of a corporation enjoy broad protection from being held personally responsible for the debts and liabilities of the corporation. That is, creditors can reach the corporation's assets but, once those assets are exhausted, they cannot ordinarily also reach the personal assets of the owners or shareholders of the corporation.Under some circumstances, those to whom the corporation is liable will attempt to "pierce the corporate veil", a legal term used to describe an action to have the corporation set aside for purposes of the litigation such that personal liability attaches, and personal assets of the shareholders can be reached.
An action to pierce the corporate veil most often arises in civil litigation when the corporation is believed to have inadequate assets to cover its liabilities, and the plaintiff alleges that the corporation is actually a sham - that is, the corporation is not really a distinct individual, but is merely an extension or alter ego of its shareholders, being used to advance their private interests or to perpetrate a fraud.
A corporation offers strong protection to its shareholders, and most efforts to pierce the corporate veil are rejected by the courts As the precise facts and circumstances which can result in a piercing of the corporate veil will vary depending upon state law, and as piercing the corporate veil is a fact-dependent inquiry, it is important to consult with a qualified lawyer when evaluating whether the corporate veil may be pierced in any specific case. .
Generally, when evaluating if a corporation is in fact legitimate or if the corporate veil should be pierced, courts look at the following factors:
Corporate Formalities - Did the corporation follow proper procedure, for example in its formation and appointment of directors, issuance of stock, the holding of its annual meetings, the filing of annual reports with the state, and the maintenance of its own property, and financial books and accounts? Or were the procedures not followed, was the corporation dependent on property or assets of a shareholder which it did not technically own or control, did the shareholders commingle their assets with those of the corporation, or were the corporate finances commingled with those of its shareholders?
Individual Control - What amount of financial interest, ownership and control did the principals maintain over the corporation?
Personal Use - Did the principals use the corporation to advance personal purposes?
Evidence of Fraud - Is there evidence that the principals of the corporation used it to commit a fraud, to engage in wrongdoing, or to perpetrate what amounts to an injustice to those seeking relief
If the court examines those factors and concludes that there is such unity of interest between the corporation and its shareholders that they are inseparable, and that it would be unjust to permit the corporate form to stand, a court will typically pierce the corporate veil.
A court may also pierce the corporate veil to prevent a fraud, where the corporation is found to be a sham, created to facilitate fraud against third parties. If the corporation was set up, for example, to shield its owners from liability over a fraudulent real estate deal, and the owners siphon out the corporate assets such that the corporation is unable to compensate the victims of the fraud, a court is likely to set aside the corporation and allow the victims to recover from the personal assets of the owners.
Sometimes a business will operate through multiple affiliated corporations. For example, a corporation may create a separate entity to participate in a joint venture with another company, or may create a subsidiary corporation to engage in certain types of business activity. Where an affiliated corporation lacks sufficient assets to cover its obligations, an effort may be made to pierce the corporate veil in order to reach the assets of the parent corporation. When a court examines a parent-subsidiary relationship, factors a court may consider when evaluating if the subsidiary is in fact a separate business or simply an alter ego that should be disregarded, such that the parent corporation may be held liable for its obligations, include:
Control - Does the same person control both the parent and subsidiary?
Location - Do the parent and subsidiary operate out of the same facility?
Business Activity - Did the subsidiary perform its business activities through its own employees, or was it partially or wholly dependent on the parent corporation?
Capitalization - Was the subsidiary sufficiently capitalized, or was it dependent upon the parent?
Separate Finances - Did the subsidiary maintain its own financial accounts or were they shared with the parent?
A Limited Liability Company (LLC) has a similar purpose to a corporation, allowing the principals to engage in business activity while reducing their potential personal liability. The principals of a LLC are called "members" as opposed to shareholders, but for purposes of veil-piercing that is simply another way to describe ownership. The protection offered by a LLC relates principally to liability for the acts of other members of the LLC, with individual members normally remaining liable for their own acts and omissions and those of employees they direct.
For some LLCs, such as a law firm that operates as an LLC, there may be little need to try to pierce the veil, as the member who provided services can be sued directly, with the LLC likely carrying sufficient insurance to cover its potential liabilities. However, LLCs may be created for many other purposes, including to hold real estate, investments, or to conduct other types of business. The same principles apply to the LLC's veil as to a corporate veil, and may cause a court to set aside the LLC to hold all members personally liable for its obligations. Although a LLC is easier to operate than a corporation, with fewer formalities to follow, the members should ensure that they properly follow required formalities, maintain separate bank accounts and finances, and refrain from using the LLC for personal purposes.