The corporate veil protects business owners from financial and legal liabilities of the business. It is provided to limited liability companies (LLCs) and corporations.
Piercing the corporate veil means shareholders of a business do not enjoy impunity.
Let us discuss these two concepts in detail and see how the corporate veil works.
What is a Corporate Veil?
A corporate veil or a corporate shield is a legal concept that separates the legal liabilities of a business from its shareholders, members, and related entities.
This concept protects shareholders and owners of a business from being personally liable for a business. However, if the court determines otherwise, it may hold shareholders and owners liable for business liabilities.
It means a corporate veil is not guaranteed protection for shareholders of a business. Rather, it provides a means to legal protection that requires following certain rules.
Also, a corporate shield or veil is not available to certain business entities like sole proprietorships and general partnerships. It is commonly available to business structures like an LLC, S corporation, and C Corporation.
The concept of the corporate veil applies to individual shareholders as well as business entities. In practice, a group of companies working under the ownership of another company will be structured separately.
What is the Purpose of a Corporate Veil?
Corporations and limited liability companies (LLCs) are distinct legal entities from their shareholders and members (owners). It means if a corporation or an LLC is held liable in the court, its shareholders/members will remain unharmed.
This concept of separating the business from its owners is called the corporate veil or corporate shield. It applies to subsidiaries and partially owned companies as well.
So, the prime purpose of a corporate veil is to protect the shareholders from the legal implications if the company goes to court.
The corporate veil concept is particularly useful in debt defaults. Shareholders are usually not held responsible for the financial liabilities of a corporation or LLC company.
However, this impunity is not absolute for the shareholders. They can be held legally liable if the court determines a misuse of the separate legal entity concept by the shareholders of a company.
Similarly, the concept applies to executives and directors of large companies. Their actions and decisions are held accountable as long as they serve a company. It means the company remains legally responsible for all actions and decisions are taken by a director or executive of the company.
What Does Piercing the Corporate Veil Mean?
When the court determines that shareholders and owners of a company are legally liable for financial and other obligations, their corporate veil is pierced.
It simply means a situation where shareholders and owners of a company do not enjoy impunity under this concept. It happens because owners and shareholders can be held responsible for their actions and decisions.
The piercing concept usually indicates a court decision against the owners or managers of a company. Under normal circumstances, auditors and executives cannot determine whether the corporate shield has been broken (pierced) or not.
Creditors and lenders cannot sue shareholders of a corporation or LLC if the company goes bankrupt or defaults on a loan. However, they can sue shareholders if they can prove wrongdoings from them affected the default.
It means when a corporate veil is pierced, shareholders and owners become personally liable for the repayment of debt obligations of the company. Lenders and creditors can then go after the personal assets of shareholders to recover their debts.
For large corporations and public companies, only those shareholders or directors can be sued who are proven guilty. It means even if lenders/creditors go to court, not all shareholders can be held liable for the wrongdoings of a few individuals.
When Does a Corporate Veil Pierce?
Corporations and LLCs are registered with state regulators usually. Therefore, each state determines what constitutes a piercing of the corporate veil.
Usually, the court determines the piercing of the corporate veil by analyzing different factors. So, there cannot be a single set of factors to determine.
Here are a few common reasons why a corporate veil can be pierced by the court.
Failure to Maintain Separate Legal Entity Status
It happens when the shareholders of a company do not separate the financial aspects of a business from personal matters.
In practice, this breach of the separate entity rule happens when shareholders keep using personal bank accounts for paying and receiving money from the business.
Similarly, it occurs when shareholders keep using business assets for personal uses.
Non-Separation of Subsidiary Companies
A similar concept to the first point is the non-separation of subsidiary companies from their parent company.
If the legal and financial aspects of subsidiaries and parent companies are not separated, it pierces the corporate veil. However, it does not include legal transactions to and from the parent company or issues like transfer pricing.
Failure to Provide Adequate Capital
Each business comes with certain capital financing requirements. Shareholders are not responsible for funding these requirements through equity.
However, they must provide adequate financial resources to a business as and when needed. Also, assets owned by a business should be adequate to pledge against loans for the security of lenders and creditors.
Non-Compliance with Corporate Governance Rules
Corporate governance rules require setting up a system that ensures internal controls in a business. These actions include creating formal bookkeeping records, financial statements, auditing, segregation of roles, and so on.
Again, there are no hard rules to determine whether the shareholders fulfilled these requirements. Rather, the court will judge this breach collectively.
Fraud, Wrongdoings, and Injustice to Stakeholders
One of the most common reasons for the piercing of a corporate veil is fraud and wrongdoings of the shareholders of a company.
If the court finds shareholders/directors involved in fraudulent activities, the corporate shield will be broken.
Injustice to stakeholders means practicing policies that are harmful to others. For example, charging an unfair or misleading price or deceptive marketing campaigns harming buyers.
Non-Functioning Corporate Offices
One of the key requirements of corporate governance rules is to judge whether a subsidiary company can take decisions independently.
Also, this point relates if the subsidiary company owning separate offices. Subsidiary and parent companies can have the same office space but the subsidiary decisions should be independent of that of the parent company.
How to Protect Yourself from Piercing the Corporate Veil?
Businesses should carefully evaluate the corporate governance requirements to avoid legal actions and consequences like piercing the corporate shield.
Here are a few steps shareholders and businesses should take to avoid such consequences.
Separate Entity Structure
Many businesses create a separate entity structure on paper. However, if you want to save yourself from legal troubles, do it practically too.
Run your business as a separate legal entity from your personal financial matters. It will help you avoid legal and financial complications that could result in the piercing of the corporate veil later.
Maintain Separate Records
One of the core concepts of the separate legal entity method is to keep separate financial records for your personal and business matters.
For example, you should never use a business credit card for personal purchases. Similarly, do not use your personal bank account for direct business payments or receiving income.
Do Not Use Business Assets
If you use assets for both personal and business uses, you should apportion the benefits of the use as well.
For instance, if you use a personal vehicle for business purposes as well, you should allocate vehicle expenses proportionately. So that you do not take undue business and take advantage.
It will help you maintain the regulatory requirements for keeping the corporate shield intact as well.
Documenting Inter-Company Transactions
Subsidiaries in a group often make financial transactions. If you keep an accurate financial record of these transactions, you’ll abide by the law.
Without comprehensive inter-company records, you cannot protect the corporate shield rules either.
Arrange Adequate Capital
Finally, arrange adequate financial resources for your business. It does not mean providing all financial resources through equity capital though.
You should provide the necessary equity capital and arrange debt financing whenever needed. The purpose is to fulfill the financial needs of a business to avoid financial troubles like bankruptcy and debt defaults.
