Piercing the Veil of Limited Liability

 

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In order to avoid day-to-day liability risks when enacting an asset protection plan, a small business owner must pay close attention to recordkeeping and initial capitalization to steer clear of the doctrine of "piercing the veil" of limited liability.

The veil is the shield of limited liability that stands between the owner of a limited liability company (LLC) or corporation, and the business's creditors. Ordinarily, because of this valuable legal shield created when you formed your business entity, the business's creditors can only seek payment out of the business's assets.

When this veil is pierced, the business's creditors can reach the owner's personal assets outside of the business. In short, limited liability, perhaps the most important attribute of an LLC or a corporation, is lost.

This is a complete exception to limited liability. Unlike the financial withdrawal and transaction exceptions in our discussion of limiting liability for contracts and torts, this exception does not apply to a particular business debt. It applies to all of the business's debts, if it applies at all.

However, this exception will arise in a lawsuit by a particular creditor of the business, who is seeking in a complaint to impose personal liability on the owner of the business. In other words, the creditor must sue the business owner personally, plead the doctrine of piercing of the veil of limited liability in his complaint, and then prove to the court that the doctrine should be applied to that particular case.

Of course, this type of lawsuit is even more likely in a business that has little capital within the business form, where the debt in question is unlikely to be satisfied from the business's assets. In fact, piercing of the veil of limited liability is regarded as one of the most frequently litigated issues involving small businesses.

The courts will apply this doctrine if the creditor can prove either one of two legal theories:

• Alter Ego Theory - The creditor must establish that the business owner failed to separate his financial affairs from the entity's financial affairs, and/or observe statutory formalities regarding division of authority within the entity, required meetings, and recordkeeping.
• Undercapitalization Theory - The creditor must prove that the owner intentionally underfunded the entity, when it was formed, to defraud the business's creditors.

Warning There are circumstances where the piercing of the veil will automatically apply, and thus the owners of the business will automatically lose their limited liability. LLCs and corporations must renew their status annually by filing a report with, and paying a fee to, the state in which they were formed. Failure to file the report and pay the fee will cause the corporation to go into "bad standing" with the state. After a certain amount of time, which varies by state, the state will dissolve the entity. If this happens and the owner continues to operate the business, the owner is then operating a sole proprietorship if there is one owner, or a general partnership if there are two or more owners. Either way, the owners have unlimited, personal liability for all of the business's debts. Other events can trigger dissolution of the business and produce a similar result. However, these events can be controlled in an entity's articles of organization and operating agreement, or bylaws. Finally, don't confuse a failure to renew the entity annually or biannually, which triggers an automatic dissolution, with failure of an LLC or a corporation to register as a foreign entity when it does business in a state other than the state in which it was formed. Here, the failure, in most states, does not trigger dissolution, and the foreign entity's contracts and limited liability remain intact. In some states, however, this failure, too, can cause dissolution.