Owning your own business comes with a great sense of pride, but it can also be accompanied by the fear of losing everything in a lawsuit. One way to protect yourself from liability is to form a corporation or a Limited Liability Company (LLC). Forming a corporation or an LLC rather than operating as a simple partnership or a sole proprietorship is important because corporations and LLCs provide liability shields for their owners and shareholders that offer protection from personal liability.  Although, the proverbial liability shield offers strong protection, that shield is not impenetrable. Under certain situations individual liability can be imposed against the members of a corporation called piercing the corporate veil. This article will explain situations in which the corporate veil can be pierced, and how business owners can better protect their individual assets.  This article will concentrate on corporations, but some of same rules apply to LLCs.

What is a liability shield anyway?

A corporation is treated distinct from its shareholders and this distinction prevents a claimant from imposing personal liability upon the shareholders that arises from actions of the corporation. In essence a corporation is treated as a person itself. This protection is commonly referred to as a liability shield. A liability shield is important because, with limited and fact-specific exceptions, when a corporation is sued, the plaintiff cannot recover damages from the individual shareholder’s personal assets such as their homes, bank accounts, or other property; rather, the plaintiff’s recovery is limited those assets owned by the corporation.

How strong is this liability shield?

Although, a liability shield does provide strong protection to a shareholder, like most things, it is not impenetrable. A court can disregard the corporate form, pierce the corporate veil, and extend liability to the shareholders of a corporation when it is necessary to prevent fraud or to achieve equality. Piercing the corporate veil is possible, but as one Court has described, it “is a strong step: like lightning, it is rare and severe.”[1]

Piercing the corporate veil may not happen often, but when it does, it can be detrimental to the shareholders of a corporation. A $25,000 judgment against your corporation may not sting as much as a $25,000 judgment against you personally.

When can the corporate veil be pierced?

There is not a bright line rule determining when the corporate veil can be pierced, rather courts apply a test and a set factors to determine if piercing the corporate veil is appropriate in each individual case.

Courts use a three part test to determine if an individual can be held personally liability arising from a corporation. The court will consider:

  1. Whether control by the shareholders is of such complete domination so that the corporate entity has no separate mind, or no existence of its own;
  2. Whether the shareholder used the corporation to commit a fraud or wrong, to perpetrate the violation of a legal duty, or a dishonest and unjust act; and
  3. The control and breach of the duty must have caused the injury to the plaintiff.

As you can see, this three part test is vague.  In order to give us a better understanding of when it is proper to pierce the corporate veil, courts have provided a list of factors that are considered when piercing the corporate veil. These factors are:

  1. Inadequate capitalization of the corporation;
  2. The failure to comply with corporate formalities;
  3. Complete domination and control of the corporation so that the corporation has no identity separate from the shareholder;
  4. Excessive fragmentation of a single enterprise into separate corporations;
  5. Nonfunctioning officers and directors; and
  6. The absence of corporate records.

Although, none of the factors above are decisive, and may not be relevant in every case, they can be used as a guide to determine if piercing the corporate veil is a risk.  The presence of one of the factors may not automatically subject an individual to liability, but the more factors that apply the more likely it is that a court may pierce the corporate veil.

How do I protect myself?

Although, piercing the corporate veil is a possibility, there are ways that you can protect yourself from liability. First, it is important to ensure that your corporation is adequately capitalized based on the ordinary practices of your industry. For example, corporation formed for a construction company will likely need more capitalization and hard assets than a marketing agency. Second, ensure that you are not using corporate funds for your individual needs and expenses. Keep your personal and corporate assets separate. Third, keep up the required corporate formalities and corporate records. Conduct your annual meeting, keep good corporate records, and make all corporate decisions based on your bylaws. Lastly, treat your corporation as a separate entity from yourself.

Although, it is not a frequent occurrence, an order piercing a corporate veil is a risk that can have detrimental effects, but it is something you can avoid. When you are setting up your corporation seek the help of a legal professional and if you have questions ask. It is better to make changes in the beginning rather than when you are facing a lawsuit, and it is too late.

[1] State ex rel. Cooper v. ridgeway Brands Mfg., LLC, 362 N.C. 431, 349, 666 S.E.2d 107, 112 (2008).

Published by Davis W. Puryear on February 27, 2018.