Your corporate veil protects both you and your business.
Here’s how to avoid piercing the corporate veil.
What Is Piercing the Corporate Veil?
It will help to begin with a definition of the corporate veil. The concept of corporate personality and lifting the veil go together. The idea of corporate personality is the notion that a corporation is a legal entity distinct from its members, managers or shareholders.
This gives corporations the right to bear a distinct name, buy and sell property and sue or be sued. It also requires corporations to have a unique federal tax identification number and file their own taxes, except in cases where tax liabilities pass through the business to its owners, as in the case of a limited liability company (LLC) or S corporation.
One benefit of the corporate veil is it provides a degree of protection for business owners and others associated with a company. When the corporate veil is in effect, business owners are not legally responsible for the corporation’s tax obligations, debts and lawsuits. For example, if a business declares bankruptcy, this does not necessarily mean the owner must also declare bankruptcy.
However, the separation between business owners and corporate liability isn’t absolute, and can be legally removed in some situations. The principle of lifting the corporate veil is the concept that corporate protections to business owners and associates may not apply under certain circumstances.
As legal guide provider Nolo notes, piercing the corporate veil examples include cases where:
- A corporation has engaged in fraudulent behavior, such as behavior masking its relationship to its owners
- A corporation failed to follow proper formalities to create or maintain a corporate veil, such as failing to file the necessary paperwork to establish a corporate identity, neglecting to hold shareholder meetings or mixing company and personal finances
- A corporation has never had enough capital to run its operations or pay its creditors (a situation described as being undercapitalized), so that its financial independence from its owners is questionable
- A corporation is controlled by a small group of related people
To illustrate a scenario that might result in piercing the corporate veil, LLC owners who are acting as a front for a parent company to help the other company avoid repaying creditors may face a lawsuit where the court decides the corporate veil doesn’t protect the owners from liability. Fraudulent practices such as this are the most likely reasons a court may rule to pierce a corporate veil, but the other scenarios described above can also serve as grounds.
Now that we’ve covered what piercing the corporate veil is, let’s look at 10 strategies you can use to avoid it.
1. Set Up a Corporate Structure for Your Business
The first step to establishing a corporate veil is to set up an eligible structure for your business. In the U.S., business structures protected by a corporate veil are:
- C corporations, which pay tax on business income
- S corporations, which do not pay tax on business income but pass tax liability on to company owners
- LLCs, which are simpler to administer than C corporations and S corporations and can elect to be taxed as either sole proprietorships, partnerships, C corporations or S corporations
Sole proprietorships and partnerships aren’t eligible for corporate veil protection. Their owners can be held liable for their company’s debts.
Each type of business structure has its own pros and cons. If you aren’t sure which structure to choose, talk to a knowledgeable corporate lawyer.
2. Create Corporate Contact Information
To help distinguish your corporate identity from your personal identity and that of any co-owners, use corporate contact information rather than personal contact information.
This should include:
- A corporate address
- A corporate email address
- A corporate website
- Corporate social media profiles distinct from personal social media profiles
Using a corporate address distinct from your personal address helps keep your personal finances separate from your business, which is important for maintaining your corporate veil.
Some companies use the address of their registered agent as their business address. However, if you aren’t your own registered agent and you don’t actually own or control your registered address, this risks piercing your corporate veil. Instead, use an address under your control or pay for a virtual office or mailbox.
If your corporation is run by a parent corporation, make sure you aren’t using identical contact information for your parent corporation. Doing so could be used to build a case that you’re acting as an alter ego of your parent corporation.
3. Use Your Corporate Information for Marketing and Communications
After creating corporate contact information, it’s important to publicize it. Use it on marketing and communications material, such as:
- Business cards
- Business correspondence
This will help document your use of your corporate information.
4. Use Separate Financial Accounts
Mixing your business and personal finances can pierce your corporate veil. To avoid this, create financial accounts for your business that are separate from your personal accounts.
This applies to:
- Business bank accounts
- Business credit cards
- Business lines of credit
Keep the records of your business transactions separate in your books from your personal transactions. In accounting software, you can do this by using separate workbooks. If you prefer to use one workbook for convenience, you can create a separate line item for personal bookkeeping.
5. Handle Payments to Yourself Properly
To maintain the distinction between your business and personal finances, it’s important to handle payments to yourself properly. The way you pay yourself as a business owner varies with your business structure:
- If you’re a sole proprietor or the owner of a single-member LLC, you pay yourself through an owner’s draw, where you pay yourself from company funds
- If you’re a C corporation owner who is active in company operations, you pay yourself a salary as an employee
- If you’re a C corporation shareholder who isn’t active in company operations, you receive payment through dividends
- If you’re a partner in a partnership, a multiple-member LLC member or an S corporation shareholder, you receive payment through distributive shares
If you’re paying yourself through an owner’s draw, you can maintain a clearer distinction from your personal finances if you write yourself a check rather than withdrawing funds directly to a personal account. If you’re paying yourself a salary, follow the same paperwork procedures you would use to pay other employees, including following proper procedures for filing tax forms and payroll taxes.
6. Pay Business Expenses Separately
Keeping payments for business expenses separate from personal expenses will help maintain the distinction between your business and personal finances. Make business payments using business checks or credit cards rather than personal accounts, and don’t use business accounts to pay for personal expenses. Keep receipts of all business expenses, and enter all payments into your business books.
7. Avoid Mixing Corporate and Personal Assets
Treating business assets as personal assets or as assets of a parent company can pierce your corporate veil. So can the reverse practice of using personal assets for business purposes.
For example, Wolters Kluwer points out that using a company car for personal errands can pierce your corporate veil.
8. Follow Required Formalities and Procedures
Corporations that fail to follow certain formalities and procedures can lose their corporate veil. These formalities and procedures may include:
- Maintaining corporate records, such as articles of incorporation, bylaws and tax returns
- Filing updates to your corporation with your state’s department of revenue or equivalent agency
- Holding director and shareholder meetings
- Keeping minutes at meetings
- Failing to issue stock or dividends when appropriate
Avoiding these oversights will help you maintain your corporate veil.
9. Document All Business Activity
Failing to keep certain business records can compromise your corporate veil. Business records that should be kept include:
- Accounting books
- Tax filings
- Annual reports
- Minutes from meetings of directors and shareholders
- Records of shareholders contact information and shares
- Human resources records
Keeping good documentation of all important business activities will help you preserve your corporate veil.
10. Follow a Sound Financing Strategy
Undercapitalization can compromise your corporate veil. It happens when you don’t have enough capital to conduct your business operations or keep up with debt obligations. This can happen if you aren’t generating enough cash flow or if you lack financing.
You can offset undercapitalization by doing better financial planning, increasing your sales or improving your financing strategy. For example, you can sell shares, issue debt or obtain a business line of credit or working capital loan.
Keep Your Corporate Veil Intact
A corporate veil protects you from your company’s legal and financial liability, provided you follow proper procedures. Avoid piercing the corporate veil by choosing the right business structure, keeping your personal and business identity and finances separate, following necessary formalities and keeping your business sufficiently capitalized.
If you are concerned about undercapitalization, consider seeking business financing resources. You can find out what types of options you may prequalify for in just a few minutes by filling out our free no-obligation online application.