What is Veil-Piercing?
- Entity status means LLCs are responsible for business actions or debts, not the owners.
- This protection is referred to as the LLC veil.
- If the LLC is not properly formed and operated, the owners may lose this protection.
Veil-piercing—originally a corporate concept now applied to LLCs as well—is a judicial remedy used to set aside limited liability and hold business owners personally responsible for business actions or debts. This article discusses veil-piercing and gives practical guidance for avoiding veil-piercing claims.
Entity Status Separates the Business from Its Owners
The liability protection offered by an LLC depends on entity status. Entity status means that the business entity has legal rights and obligations that are separate from its owners. Acting through its owners and managers, the entity can own and manage assets, incur debts, assume obligations, and be held responsible for its actions.
Because the law recognizes LLCs as entities, the business entity is responsible for the business debts, not the owners. If the business loses a lawsuit, the plaintiff must look to the business to satisfy the judgment. Assuming the LLC is properly formed and operated, the plaintiff may not enforce the judgment against the owners.
Example: An LLC is formed to offer consulting services. A dispute arises for breach of a consulting agreement and the LLC loses in court. The plaintiff can only look to the LLC to satisfy the judgment. The plaintiff may not enforce the judgment against the owner’s home, personal bank accounts, or other assets.
This Separation Protects Owners from Business Debts
Because the liability protection offered by LLCs depends on its status as a separate legal entity, the owners must treat the business as a separate entity. To maintain protection, owners must operate the business like a business. Protection can be lost if the owners mix personal and business funds, fail to properly capitalize the business, or do not have the right documents in place. When that happens, a court may use a remedy called piercing the veil to disregard the liability protection of the LLC and enforce a judgment against the owners.
How do Courts Peirce the Veil of Liability Protection?
Because the law favors liability protection, courts should only use a veil-piercing remedy in egregious circumstances. Most veil-piercing cases involve misconduct by the LLC or an attempt to defraud creditors (for example, by leaving the business under-capitalized or mixing business and personal assets).
Different states have different standards for veil-piercing. In Texas, for example, the veil may be pierced if any of the three veil-piercing strands are met:
- The LLC is the alter ego of the parent corporation or the shareholders;
- The LLC is used to avoid legal limitations upon natural persons or business entities; or
- The LLC is a sham to perpetrate a fraud.
The court will also pierce the LLC veil for actual fraud.1
Protect Against Veil-Piercing
The best protection against veil-piercing is to be sure that the LLC is operated like a business.
- Keep governing documents on hand. Company documents should be maintained and on hand for inspection. For an LLC, these documents include, at a minimum, the certificate of formation, operating agreement, and organizational minutes and resolutions.
- Be sure the business is adequately capitalized. The LLC should have enough funds on hand to pay its foreseeable debts and obligations. If the equity is stripped out of the business and it is left on the verge of insolvency, a court is more likely to pierce the veil.
- Use the business name in business documents. The LLC will not protect against contractual claims if an owner lists himself or herself instead of the business as a party to the contract. Although there are situations where an owner’s name will also need to be listed on documents—for example, to personally guarantee a loan—always include the LLC name on business documents and include owner names only when strictly necessary.
- Keep adequate books and records. The acts of people can be observed; the acts of businesses must be documented. Every business decision—from opening a bank account to purchasing or selling assets to hiring employees or contractors—must be adequately documented.
- Keep funds separate. The business should have its own bank account for business funds. That bank account should be used to pay business expenses, not personal expenses. If the owners need funds from the business bank account, make sure there are enough funds to pay the owner without compromising the ability of the business to pay its debts, then make a distribution to the owner. Do not pay the owner’s expenses from the business bank account.
Following these simple guidelines will help reduce the risk that a court will disregard the LLC’s liability protection.
- In Re Jns Aviation, LLC, 376 B.R. 500 (Bankr. N.D. Tex. 2007). A corporation is used in actual fraud if all of four the following factors occur: (a) a party conceals or fails to disclose a material fact within the knowledge of that party; (b) the party knows that the other party is ignorant of the fact and does not have an equal opportunity to discover the truth; (c) the party intends the other party to take some action by concealing or failing to disclose the fact; and (d) the other party suffers injury as a result of acting without knowledge of the undisclosed fact. Id.