Most of us who go to the trouble of organizing a small business as a corporation or limited liability company (LLC) assume that the resulting liability protection is absolute. It isn't.
Our homes and our cars are not maintenance free. Neither are our corporations and LLC's. But while cars and home appliances come with owner's manuals and care instructions, corporations and LLCs do not. If the attorney organizing the company doesn't educate the new business owner about the necessity of maintaining financial integrity and organizational formalities, the owner is at risk that an enterprising creditor may be able to disregard the company as a separate legal entity, and impose personal liability upon the entity's shareholders or members. This process of seeking to hold shareholders and members personally responsible for the debts of the business entity is known as "piercing the corporate veil"-a term that barely hints at the damage it can do to an unsuspecting business owner.
Historically, courts have been reluctant to pierce the corporate veil, and properly so. Without limited liability protection, the entire concept of the corporation or LLC as a separate legal entity is rendered useless. However, in Pennsylvania and in most states, the courts have long permitted creditors to pierce the corporate veil under specific circumstances defined and refined by written opinions handed down by courts over the years. Thus far, the Pennsylvania legislature has been silent on the issue of piercing the corporate veil, leaving the question entirely to the courts. Further, neither the courts nor the legislature has definitively addressed the extent to which corporate "piercing" rules might apply to LLC's, though the safe practice is to assume that if the facts are sufficient to pierce a corporation's veil, they will also be sufficient to pierce an LLC's veil.
The circumstances in which the Pennsylvania courts have allowed creditors to pierce the corporate veil, recently articulated in the Pennsylvania Supreme Court case of Lumax Industries v. Aultman, 543 Pa. 38, 669 A.2d 893 (1995), can be broken down into the categories that follow.
Of course, the primary reason why any creditor would want to punch through a company's veil and attach the assets of its owners is that the company does not itself have assets sufficient to pay the creditor's claims. If this financial insufficiency existed at the time the debt was incurred (and not merely at the time the creditor seeks to collect), and if the insufficiency is so severe as to constitute "gross undercapitalization," the courts may permit the creditor to pierce the corporate veil. However, not every cash flow problem constitutes "gross undercapitalization." The question is, how strapped must an entity be before the courts will deem it grossly undercapitalized?
There is no hard and fast rule to determine what constitutes gross undercapitalization. The determination turns on the specific facts of a particular case. There is likewise no requirement that a corporation or LLC must be flush with cash in order to preserve its limited liability. Instead, the courts look to the particular capital and cash flow needs of the particular business entity. If a corporation's capital needs are low, marginal capitalization may be deemed sufficient-so long as the capitalization is adequate for purposes of that corporation's operations. Likewise, if a particular LLC's primary potential liability is a negligence liability or other tort liability (as opposed to inventory purchases and other contract liabilities), the company may be adequately capitalized even if it has no significant capital-so long as it has insurance capable of covering its potential tort liabilities. However, if a corporation takes on a new project and new liabilities at a point when it can't even meet its current obligations, the business will be doing so with the risk that creditors may be able to look to the individual shareholders for payment once the corporation's coffers have been depleted. While there is no bright line test for "gross undercapitalization," it is fair to say that the greater the appearance that the corporation knew at the time it incurred a debt that it wouldn't be able to pay, the greater the likelihood that a court will permit the company's veil to be pierced.
It is a fundamental requirement of corporation law that each year the corporate shareholders must elect a board of directors, which in turn must elect a slate of officers (president, secretary and treasurer at a minimum). It is also fundamental that a corporation must keep records or minutes of its proceedings. With most LLCs, annual elections are not required, which is an advantage for LLCs over traditional corporations. However, whether the entity is a corporation or an LLC, the absence of annual minutes on the company books provides creditors' counsel with the argument that the entity has failed to comply with formal requirements (e.g., annual elections, entity approval of major sales and acquisitions, etc.), and may provide a basis for piercing the corporate veil even when the entity's undercapitalization does not rise to the level of "gross."
Part of the underlying theory of piercing the corporate veil is that where a dominant shareholder has used corporate assets as if they were his or her own, thereby ignoring the separateness of the company as a distinct entity, there is no reason why the rest of the world should not also be permitted to ignore the separateness of that entity. Therefore, where the dominant shareholder of a corporation has failed to attend to annual elections of directors and officers, thereby effectively eliminating those positions or rendering them meaningless, the courts will occasionally allow a creditor to pierce the corporate veil due to the corporation's lack of compliance with formalities.
It is again worth noting that because there are fewer formalities involved in the operation of an LLC than in the operation of a corporation, the LLC format may provide a small business owner with a greater measure of limited liability protection. As a word to the wise, it is worth stressing that it is important for every organized business to prepare and file annual minutes, whether the business be a corporation or an LLC.
Intermingling of Assets
In a solely-owned or family-owned corporation or LLC, it is very tempting for the president to pay for his grocery bills or even his child's tuition bills from the business account. After all, it is easier to pay bills in this fashion than to write one check to cover the owner's salary and then a second check from the owner's account to pay the tuition or grocery bill. This is particularly true when the owner's scheduled salary or draw will not be enough to cover the particular bill. On this question, it is important to understand that the overriding principle of piercing the corporate veil is that equity requires the court to disregard a shareholder's traditional insulation from personal liability if the corporate form is used as a sham or facade for the pleasure of a dominant shareholder. Accordingly, any substantial intermingling of company assets and personal assets may result in the unsuspecting shareholders or members being subjected to personal liability for company debts.
However, lest it be said this article is unduly alarmist, it should also be understood that courts are not unthinking or mechanical in their approach to piercing the corporate veil. For instance, it is unlikely that any court will pierce a corporation's veil simply because the shareholders forgot to prepare minutes or records for a single year or because the president may have paid a few personal expenses from the corporation's accounts, particularly if the accounting errors are later rectified. In the absence of undercaptialization, which is ultimately the gravest of sins for which a court might pierce a corporation's veil, the courts generally will not set aside a corporation's limited liability on the basis of no more than a few minor irregularities.
Perpetration of Fraud
It is often said that one of the primary purposes of permitting a creditor to pierce the corporate veil is to prevent unscrupulous shareholders from using a corporate shell to perpetrate fraud on creditors. In fact, the Pennsylvania courts have increasingly cited "use of the corporate form to perpetrate fraud" as a separate ground for piercing the corporate veil.
The courts have offered little guidance as to what instances of fraud might justify stripping a corporation of its cherished limited liability protection. As a practical matter, if a corporation is grossly undercapitalized, the creditor will not be required to prove a particular fraud. Conversely, if the corporation is adequately capitalized, the creditor will rarely have any reason to pierce the corporate veil on fraud grounds, or on any other grounds.
It is now more than twenty years since the Pennsylvania Superior Court wrote that "there appears to be no clear test or well settled rule either in Pennsylvania or in the country at large as to exactly when the corporate veil can be pierced and when it may not be pierced." Kellytown Co. vs. Williams, 284 Pa. Super. 613, 623, 426 A.2d 663, 668 (1981). Although the Pennsylvania Supreme Court has since provided some measure of clarification in the Lumax Industries decision, owners of small corporations and LLC's have not yet seen the day when they can predict with certainty that they will have no risk of being denied their limited liability protection. Until the courts hand down a definitive corporate owner's manual, shareholders of small corporations and members of LLC's are well-advised to consult with their attorneys and use common-sense preventive maintenance to keep their limited liability protections in good working order.
The attorneys of Wolf, Baldwin & Associates, P.C. can counsel you on piercing the corporate veil and other corporate limited liability issues. Please click here to contact us today to talk to one of our attorneys about your business. We look forward to hearing from you.
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