Forming a business entity like an LLC or a corporation typically provides limited liability protection to the owners. But in certain situations, you can find yourself personally on the hook for the debts and obligations of the business. This week we’re discussing the legal concept of “piercing the corporate veil” and why it’s used so often against small business owners.
Generally speaking, when you establish a business entity with the Ohio Secretary of State, you are creating what the law considers a separate legal “person.” In other words, there is a “veil” between the owners of a business and the business itself. This is true even when the business entity is only owned by one person. It’s true of both LLCs and corporations. (So no, a corporation is not somehow “better” than an LLC. One does not provide more protection than the other.) And it’s true of parent companies that own subsidiary businesses. (No, creating a subsidiary does not provide “more” liability protection.)
However, when businesses encounter financial or legal difficulties, the courts may “pierce the corporate veil” and hold the owners personally responsible for the debts and obligations of the business. In other words, having an LLC or a corporation does not mean that you can never be sued for what happens in the business. (It’s also not a magic trick for protecting all of your personal assets from your creditors.)
Piercing the corporate veil is often used against small businesses in particular because of the assumption that, as the owner, you have taken (or will take) all of the money out of the business for yourself. Think about it from the viewpoint of your creditor or a disgruntled customer, vendor, business partner, or even former employee who is considering a lawsuit. They often believe (or assume) that if they sue the business, you’ll just take all of the money out of the business, hide any assets, or shut the business down to avoid liability. So instead of just suing the business, they sue both the business and the individual owner(s). And they use this concept of veil piercing in order to do so. (Again, the same is true for subsidiary business entities. If there is a suspicion that the parent entity has more resources than the subsidiary entity, then the plaintiff will attempt to use veil piercing to get to the parent entity and its assets or to the individual owners of the parent entity and their assets.)
The Legal Standard for Piercing the Corporate Veil
In deciding whether to pierce the corporate veil, the courts focus on 3 factors :
Piercing the corporate veil is supposed to be a “rare exception,” only applied “in the case of fraud or certain other exceptional circumstances.” Breaching a contract or committing some negligent act should not, in theory, be enough to pierce the veil and sue you as a small business owner. However, it’s a tactic we see used all the time against small businesses and their owners.
How does Veil Piercing Work in Practice?
So how do you minimize the chance of finding yourself named in a lawsuit against your business?
1. Run Your Business Like It’s a Fortune 500 Company
Separate yourself as an individual from your business, and run your business like a business. Does your business have its own bank account? Is that account only used for legitimate business expenses? Does the business have and follow corporate bylaws or an LLC operating agreement? If you have business partners, do you have regular meetings and document those meetings with meeting minutes? Plaintiffs will look for any excuse to argue that you that you aren’t treating your business like a “real” business. Blurring the distinction between you as an individual and the business you own and operate is an invitation for a court to pierce the veil and hold you personally liable for business activities. Similarly, if you run multiple businesses or subsidiaries, make sure they are all operated as if they were truly separate, individual businesses.
2. Keep the Business Funded
In legal terms, is the business “adequately capitalized”? Does the business have enough money in its own bank account to pay its bills as they come due and to keep the business running? Are you, as the owner, using the business to borrow more than the business can really afford? If your business is constantly “robbing Peter to pay Paul” by purchasing supplies or services on credit in the hopes that future cash flow will arrive on time to make everything balance out, then the business isn’t adequately capitalized. And when that happens, you can’t really be surprised when your creditors want to pierce the corporate veil to hold you personally responsible for the debts.
3. Avoid Personal Guarantees
Banks and commercial landlords often make this impossible, but if you can, avoid personally guaranteeing any business debts or obligations. When you sign a personally guarantee, you are agreeing to personal responsibility for the debt or obligation, which really defeats the purpose of forming a business entity in the first place. Often, a personal guarantee will say that you, as the guarantor, and the business are “jointly and severally liable” for the debt or obligation. This means that the creditor or landlord can sue you, the business, or both for the amount owed, and they can collect the entire debt from you or the business or in any division between the two. This can be particularly problematic when both you and your business partner sign a personal guarantee because, in practice, this means that the bank or landlord will try to collect the entire debt from whomever happens to have more assets. It’s then up to you to go after your business partner for their fair share of the debt.
4. Do Business in the Name of the Business Entity
First, make sure the business is named as the party in any business contracts, and make sure you are signing in the name of the business. Too often, small businesses will enter into a contract for services with a client or customer where the opening paragraph of the contract describes the parties as “Client Joe Smith” and “Service Provider Jane Doe” instead of “Client Joe Smith” and “Service Business, LLC.” If you are the party to the contract and something goes wrong, Client Joe Smith has to sue you because your business isn’t a party to the agreement. Similarly, the signature block at the end of the contract should clearly identify that you are signing as an authorized person on behalf of the business:
Business Name, LLC:
/s/ Jane Doe,
President of Business Name, LLC
Second, while there will be times that you only use your trade name or DBA, particularly in marketing materials, it should still be obvious to your customers, clients, vendors, strategic partners, and prospects that they are interacting with a business entity. Your website, business cards, invoices, proposals, etc. should, at some point, identify the legal name of the business entity, and include the appropriate “LLC” or “Inc.” at the end of the company name.
5. Don’t Commit Fraud
It should go without saying, but if you are using your business entity to cheat your customers or business partners, then there’s a good chance the courts will pierce the corporate veil to get to you. And if you think that simply shutting down one entity, transferring the assets to another, and running a nearly identical business will save you, the courts have been known to see through that sham as well.
 Dombroski v. Wellpoint, 119 Ohio St.3d 506, 510-12 ¶ ¶18, 29 (Ohio 2008).
 Dombroski, 119 Ohio St.3d at 510 ¶ 17 (Ohio 2008) (quoting Dole Food Co. v. Patrickson, 538 U.S. 468, 475 (2003)).
These may seem like simple or obvious errors to avoid, but we see small business owners make these mistakes all the time. Our General Counsel Service helps small business owners minimize these and other risks in their day to day operations. If you have questions about the structure of your business operations and how to avoid veil piercing problems: