How Business Debts & Liabilities Can Become Your Personal Problem
E.J. Simonsen | Mar 21, 2022
If your business is dealing with aggressive debt collectors, is at risk of bankruptcy, or is overwhelmed with significant debt, you may be looking at what options are available to you. One very important consideration that is too often ignored is the risk of piercing the corporate veil. Currently, there's very little helpful information about what that is, and how it can impact business owners, especially those with small businesses. This article will provide an in-depth look at what piercing the corporate veil is, why it's bad, and how business owners can avoid this. Let's start with a definition.
What is Piercing the Corporate Veil?
The “corporate veil” refers to the separation of a business from its owners. The idea behind a corporate veil is to keep a corporation or LLC separate from the people who own and manage it. In the event of a legal or financial issue, when the corporate veil is intact, owners or managing partners cannot be held responsible for the company's actions.
This is why most business owners opt to form an LLC or corporation, instead of a sole proprietorship. The formation of an LLC or corporation shields the owners from future liability for the company's actions.
But, when courts hold an LLC or corporation's owners, members, or shareholders personally liable for the company's debts, even when those debts are not personally guaranteed, it's considered "piercing the corporate veil."
In plain terms, piercing the corporate veil happens any time a court holds a business owner or managing member legally or financially responsible for the company's actions.
When Will Courts Consider Piercing the Corporate Veil?
As mentioned, most business owners opt to create an LLC or corporation to avoid the liability associated with a sole proprietorship. But, an LLC or corporation isn't a bulletproof solution, and there are a few key situations where a court will consider piercing the corporate veil to hold an owner or managing party responsible for the company's actions.
Four key reasons why courts will pierce the corporate veil include:
1. The business owner was unable to keep a formal legal separation between the business and personal finances.
If creditors convince the court that there's no real separation between the company and its owner, the court may consider piercing the corporate veil. Common examples include:
Paying for Personal Expenses Out of Business Account
If a business owner pays bills from a business checking account, instead of paying them out of their salary or owner's draw, the court may consider piercing the corporate veil.
Commingling of Assets
Commingling business and personal assets is another reason the court may consider piercing the corporate veil. This could happen if the business accepts payments in the owner's name, or if the owner transfers money back and forth between business and personal accounts without proper documentation.
Owner Signs Business Documents in Their Name
On business-related documents, it's important that the corporation sign the document, rather than the owners themselves. This helps to keep that corporate veil intact and reinforces the true separation between the business and the owner or managing partner.
Failure to Keep a Corporate Document Binder
Proper business documentation of important meetings, notably initial and annual meetings of directors, shareholders, members, and managers, is also an important way to maintain the corporate veil. When your corporation or LLC conducts these meetings, make sure someone is dedicated to taking meeting notes and storing those notes in a corporate document binder. This binder should also keep copies of materially significant contracts the company enters, as well as any annual reports or other essential documents.
2. The company's actions were wrongful or fraudulent
A court may also consider piercing the corporate veil in the event that the company's actions were wrongful or fraudulent. Common examples include:
- The court decides that business owners or managers recklessly borrowed money
- The business made deals knowing that it could not afford the invoices
- The business used deposits for future jobs to pay for current expenses
- The business and its owners acted recklessly or dishonestly
While a corporation or LLC can protect business owners from some liability, if business owners act recklessly, especially when it concerns business finances, the court may consider piercing the corporate veil to hold those parties responsible.
3. The company's creditors suffered an unjust cost
In many debt restructuring and business bankruptcy cases, it's common that creditors, especially unsecured creditors, will not receive full reimbursement of what they've loaned. In many cases, this is something creditors grudgingly must accept.
However, if the court finds that the business owner used the creditor's inventory or funds to pay for items beneficial to the owner, the court may try to correct this by piercing the veil.
4. The company could not operate on its own
Finally, if the court finds that the company didn't have the funds or was never truly a separate entity from the owner, there is potential for piercing the veil. If the owner was continually putting more money into the company, and it wasn't becoming profitable, this is an example of when the company couldn't function as an entity separate from the owner.
When Can the Corporate Veil Be Pierced In Texas?
Texas has a relatively firm stance against veil piercing. In most cases, Texas courts will not pierce the corporate veil. The only exception would be in extreme cases where the court has determined that a corporation has been used as an alter-ego or sham for fraudulent activities. Otherwise, so long as owners and managers were operating in good faith, kept required documentation, and working to lawfully keep the business afloat, courts in Texas are unlikely to pierce the corporate veil.
How to Avoid Piercing the Corporate Veil
Even though it is unlikely that a court will pierce the corporate veil in Texas, it does happen, and it's a best practice to keep your business and personal finances separate and well-documented. Here are a few ways to avoid piercing the corporate veil.
Follow the Necessary Business Formalities
If your business just has one or two employees, it might feel silly to hold an annual meeting and take notes, but it's an essential part of maintaining your business and preserving that corporate veil. Here are a few formalities every business should follow, depending on whether your business is a corporation or an LLC:
To avoid piercing the corporate veil, corporations should:
- Create and regularly update bylaws
- Issue shares of stock to owners and properly maintain a stock transfer ledger
- Hold and document both initial and annual meetings of directors and shareholders
- Use and record corporate resolutions for significant decisions. One example might be offering liens on collateral (property, receivables, etc.)
- Undertake annual filings required by the state
- Pay any filing fees and corporate taxes
To avoid piercing the corporate veil, LLCs should:
- Undertake annual filings required by the state and be sure to pay all filing fees
- Create and update the LLC's Operating Agreement
- Hold initial and annual meetings of members
- Issue membership certificates to owners and keep a membership transfer ledger
- Use and record corporate resolutions for significant decisions. Similar to a corporation, this may include offering liens on collateral (property, receivables, etc.)
Document All Important Business Actions
Again, many small businesses feel they're too small to need to document every single move, but the more documentation you have, the better. If you're having a hard time remembering or finding the time to document business actions, try setting up a monthly or quarterly meeting that's dedicated to documentation.
Don't Commingle Assets
It's important to keep personal and business finances separate at all times. The more definite the separation, the more unlikely it is that a court will pierce the corporate veil into your personal finances.
Ensure Your Business Has the Money It Needs to Function
While most businesses will take loans at some point, it's important to be honest about your company's profitability. If the company does need borrowed funds to survive, be diligent about documenting that need, as well as the business's plan for paying back those borrowed funds.
Make Your LLC or Corporate Status Known
This is a simple step that can go a long way. Make sure "LLC" or "INC" is visible on all business cards, invoices, emails, etc. And always be sure to sign business documents in the company's name, not your own.
What to Do if The Veil Has Been Pierced Or You Have Personally Guaranteed Business Debt
If you've personally guaranteed business debt, or if your business's corporate veil has been pierced, it's important to know that you have options. A pierced corporate veil can be devastating to the small business owner who was just trying to keep a business afloat.
If you're struggling through a situation like this, get in touch with an experienced attorney in your area as soon as possible. If the veil was pierced less than six months ago, there is still a chance that it can be reversed. Get in touch with The Lane Law Firm's business debt relief or bankruptcy attorneys to learn more about how we can help.