Once you’ve got your business organized, you’re still not completely immune from personal liability. When the courts impose liability on individuals for the actions of the corporation, this is referred to in legal parlance as “piercing the corporate veil.” To avoid personal liability for the debts and other acts of the corporation (or LLC), you must manage your business entity as a truly distinct entity separate from the personal affairs of each owner.

The corporate coat of arms cannot simply be a façade with no real business purpose and the business must display characteristics that resemble a real and ongoing business. In closely held corporations (very few shareholders), the same people tend to act in several different capacities, and this requires an effort to maintain those distinctions. Not to mention, small business owners naturally tend to treat all income as personal income and use business assets for personal use.

Courts normally look at whether there are “a unity of interest and ownership such that the separate personalities of entity and owner no longer exist and maintaining the distinction between owner and entity would be injustice.” In other words, if the corporation or LLC is the individual’s alter ego and acknowledging the distinction would be unfair or fraudulent, the veil will be rent. It is impossible to describe everything you need to do to prevent the corporation or LLC from being seen as merely an extension of the owner. However, it is important enough that you should have a basic understanding of what you should and should not do to help protect yourself from personal liability.

A member of an LLC or shareholder of a corporation can be personally liable for many different types of claims, but they generally arise in these different scenarios:

one. Claims arising from an act or omission of the owner directly, such as negligence, fraud, illegal act or violation of a fiduciary duty of the owner;

two. Claims arising out of a contract, particularly one that was personally guaranteed by the member;

3. Liability for unpaid employment taxes, wages, workers’ compensation insurance, and unemployment contributions;

Four. Claims based on the concept of “piercing the veil” of the LLC;

5. Liability for consenting to or receiving a distribution in violation of the LLC’s operating agreement or applicable LLC statute.

These claims are not the result of choosing an LLC over a corporation, or vice versa. All of these exceptions apply equally to shareholders of corporations and members of LLCs. But, there are many exceptions to the limited liability rule. Many LLC members or shareholders will find that because of the way the business was operated, the protection against promised liabilities and business claims is not meaningful.

Important factors used to pierce the veil

The courts will generally determine whether you, or the other owners, have carried on the business as a separate and distinct entity, and not as the ‘alter ego’ of the owners, as stated. But what actions or non-actions of the owners demonstrate this in the eyes of the courts? State courts will look at all the separate facts and circumstances of each case to determine whether or not to pierce the corporate veil. There are some common factors that show a court that your business was set up as a sham or an extension of yourself. Low capitalization, where clearly shown, is an important factor. But, it is not an absolute reason to pierce the corporate veil by itself without other factors.

Here are the most common and key factors considered by courts in determining whether to pierce the corporate veil:

1. Whether the corporation follows corporate formalities (ie, creating and following the requirements and procedures set forth in the bylaws, keeping minutes of shareholder and board meetings, and creating resolutions for major company actions);

2. Absence of corporate records;

3. Inadequate capitalization. The corporation is undercapitalized at the time the transactions were entered with creditors or others who want the corporate veil lifted, or simply does not have enough capitalization for the particular corporation to function). State laws govern the formation of a corporation. Inevitably, these laws establish amounts or formulas to determine the minimum amount of capitalization required for a corporation. You should check your state laws to determine the amount and make sure you meet the contribution minimums. Simply put, the lack of capitalization means that the corporation was never a viable entity because it did not have sufficient funds to support the debt obligations;

4. Whether the major shareholders are using the corporation’s money for their personal use (ie, when shareholders take money from the corporation to pay their personal bills or buy gifts for themselves, etc.) or when they use other assets for personal use or gain;

5. Non-performance of other officers or directors (having officers and directors who do nothing and were appointed by a majority shareholder, but who do not actively participate in the conduct of the business and affairs of the corporation);

6. Mix of funds and other assets between the major shareholders and the corporation (or LLC);

7. There are no corporate assets of any kind.;

8. Using the corporation to transfer another’s liability (usually a shareholder);

9. Failure to issue shares and pay dividends;

10. Failure to keep records of expenses and gross receipts;

11. Contract with another without the intention of never fulfilling the obligations;

12. Do not maintain transactions under arm’s length conditions with third parties.

These are not the only factors that the courts have considered, just some of the most common ones that you absolutely must follow at all times.

Piercing the corporate veil of LLCs

In general, a member or manager is not personally liable for the debts, obligations or liabilities of the LLC solely by virtue of being or acting as a member or manager. However, the concept of piercing the corporate veil does apply to LLCs and courts can and have allowed LLC members to be personally liable in some cases. Some states, including Minnesota and Colorado, have adopted statutes that specifically apply the concept of piercing the corporate veil to LLCs. In other jurisdictions, such as Connecticut, Louisiana, Georgia, California, etc., it is the courts that have generally applied the concept of piercing the corporate veil to LLCs through case decisions.

Despite what you hear about LLCs, the Members will be personally liable if the LLC’s corporate veil is lifted by a court similar to that of shareholders. Courts will apply the same general alter ego analysis used to puncture corporations, but sometimes disregarding lack of corporate formalities. While some corporate formalities are not required to be followed under the LLC organizational statutes, this does not give members of an LLC carte blanche to operate as they please and avoid personal liability. For example, annual meetings are not required under most state LLC statutes, nor are there detailed notice requirements for meetings and elections. However, certain corporate formalities common to both entities must be followed. Owners of an LLC operating an Internet business must follow the same basic recommendations that corporations must follow.

Actions of an Owner as a Director, Officer or Manager

Shareholders, officers, directors, and members of an LLC are always personally liable for their individual criminal acts. They are also always personally liable for their own direct acts or omissions that result in injury to persons or property (ie torts), even when those acts were done in the course of company business. For example, if you are an electrician and expose a faulty wire, the fact that you have formed an LLC will not protect you from this negligence.

Similarly, if you are driving the company vehicle and insult someone on the way to a business meeting, You are still forever personally responsible for their own personal actions. To the extent that you direct or authorize in your capacity as a director, officer or manager an action that is or results in a criminal act or causes damage to persons or property, you may be held personally liable. Any member who actively participates in the business of the LLC or corporation runs the risk that its action or inaction may result in personal liability. This is particularly a risk in a service business where members provide the key service. In the example I used above, if you are an electrician and you leave an exposed wire that electrocutes someone, your LLC will not protect you. The same is true if you are a shareholder.

If you make promises about your product or service that are not true, there may be a claim against the entity for breach of contract. However, if the LLC is unable to perform or pay damages, the injured party may be able to sue you for fraud or a similar claim based on your own action. Even if you have an employee who did the deed, they may not be out of the woods. If you personally hired the employee, the injured party may have a claim against you for negligent hiring if a reasonable person would not have hired that employee.