Ahead of the Curve: Protecting Yourself from Personal Liability for Corporate Debts and “Veil Piercing”
Ways Business Owners Can Help Avoid a Piercing Claim.
By Patrick J. Kearney, Esq.
Partner at Selzer Gurvitch Rabin Wertheimer & Polott, P.C.
If a business is operated as a sole proprietorship or general partnership, the owner or general partner will have 100% liability for the debts of the business. In contrast, owners of a corporation or limited liability company (“LLC”) do not automatically have liability for all of the debts of the corporation or LLC. That is the reason those entities are frequently used by individuals. Corporations and LLCs are legal forms that equity owners can use to avoid personal liability for business debts.
In cases where a corporation or LLC does not have sufficient assets to pay a claim by a creditor (including lenders, trade creditors or those injured by an entity’s wrongful conduct), those creditors often look to “pierce the corporate veil”[i] by asking a court to impose the entity’s liability upon its owners who thought they were protected from liability through the creation of the entity. There are no hard and fast rules about how to ensure that the corporate veil will not be pierced, but guidelines do exist that should be followed carefully.
Because veil piercing is a function of state law, precise rules for veil piercing differ in each jurisdiction. “Maryland courts will pierce the corporate veil only where it is necessary to prevent fraud or enforce a paramount equity.”[ii] The term “paramount equity” is undefined. To date, the current body of Maryland law has allowed veil piercing only on a showing of some sort of fraud.[iii] The District of Columbia is slightly more liberal, allowing a veil to be pierced upon a showing of “use of the corporate form to perpetrate fraud or wrong, or other considerations of justice and equity justify it.”[iv] Virginia slides in between Maryland and the District of Columbia in holding that “one who seeks to disregard the corporate entity must show that the shareholder sought to be held personally liable has controlled or used the corporation to evade a personal obligation, to perpetrate fraud or a crime, to commit an injustice, or to gain an unfair advantage.”[v]
The most frustrating issue from a business owner’s perspective is that the rules are not hard and fast as to when a court will be able to pierce the veil. “There is neither a precise formula by which to predict when courts will pierce the corporate veil since each case is [unique], nor a uniform standard to determine whether the evidence has sufficiently demonstrated unity of interest and ownership. The factor which predominates will vary in each case, influenced by considerations of who should bear the risk of loss and what degree of legitimacy exists for those claiming the limited liability protection of a corporation.”[vi] But it is clear that piercing the veil is the exception and not the rule, which generally protects equity owners from claims that arise from the operation of a corporation or LLC. [vii]
In cases where a corporation or LLC does not have sufficient assets to pay a claim by a creditor (including lenders, trade creditors or those injured by an entity’s wrongful conduct), those creditors often look to “pierce the corporate veil”[i] by asking a court to impose the entity’s liability upon its owners who thought they were protected from liability through the creation of the entity. There are no hard and fast rules about how to ensure that the corporate veil will not be pierced, but guidelines do exist that should be followed carefully.
Because veil piercing is a function of state law, precise rules for veil piercing differ in each jurisdiction. “Maryland courts will pierce the corporate veil only where it is necessary to prevent fraud or enforce a paramount equity.”[ii] The term “paramount equity” is undefined. To date, the current body of Maryland law has allowed veil piercing only on a showing of some sort of fraud.[iii] The District of Columbia is slightly more liberal, allowing a veil to be pierced upon a showing of “use of the corporate form to perpetrate fraud or wrong, or other considerations of justice and equity justify it.”[iv] Virginia slides in between Maryland and the District of Columbia in holding that “one who seeks to disregard the corporate entity must show that the shareholder sought to be held personally liable has controlled or used the corporation to evade a personal obligation, to perpetrate fraud or a crime, to commit an injustice, or to gain an unfair advantage.”[v]
The most frustrating issue from a business owner’s perspective is that the rules are not hard and fast as to when a court will be able to pierce the veil. “There is neither a precise formula by which to predict when courts will pierce the corporate veil since each case is [unique], nor a uniform standard to determine whether the evidence has sufficiently demonstrated unity of interest and ownership. The factor which predominates will vary in each case, influenced by considerations of who should bear the risk of loss and what degree of legitimacy exists for those claiming the limited liability protection of a corporation.”[vi] But it is clear that piercing the veil is the exception and not the rule, which generally protects equity owners from claims that arise from the operation of a corporation or LLC. [vii]
Here are ways business owners can help avoid a piercing claim:
- Always make sure the legal documents creating an entity or registering an out-of-state entity are correctly filed in every jurisdiction where the entity will do business before business is conducted;
- Do not let the corporate charter or LLC registration lapse or be revoked (e.g., file annual reports on time);
- Pay all corporate fees on time;
- Follow “corporate” formalities:
- Have bylaws for a corporation or an operating agreement for an LLC and follow the provisions of the bylaws and operating agreement in operating the business;
- Have regular, at least annual, meetings for the entities (this is not required for an LLC but it is good practice);
- Hold formal elections if required under the bylaws or operating agreement;
- Prepare meeting minutes for each meeting of shareholder, directors, or formal meetings of LLC members at the time the meetings are held;
- Every time that a major decision is made, e.g., to take out a loan, rent office space or vehicles, incur a significant liability, document the decision with meeting minutes or a resolution; and
- Documents (contracts, leases, promissory notes, etc.) must always be signed correctly for the company, not by the individual owner – “XYZ, Inc. (or LLC) by John Doe, President (or Member or Manager)—unless the individual owner is the party (for example, if the owner is guaranteeing a company debt).
- Capitalize the business adequately:
- Do not advance all cash to a business as a loan; make sure that there is owner equity made by cash contributions;
- Make sure that the capital contributed is enough for ordinary business needs; and
- Do not siphon off the assets of an entity to pay the owners before creditors are paid.
- Do not mingle company and personal accounts and finances:
- This means that when a business receives a check it goes straight into a business’ bank account, not the owner’s account and not the account of a related business; and
- Owner’s personal assets and the assets of a related entity should never be used to prove an entity’s creditworthiness for a loan or extension of credit unless the owner is willing to be personally obligated and expose the assets of the related entity to creditors.
- Do not “mingle entities”:
- If several businesses are operated by the same owners, each business must follow corporate formalities and be adequately capitalized—if related entities do provide funding, those transfers should be memorialized by loan documents which are actually enforced (e.g., loans should be paid when due, and interest should be charged at a commercially reasonable rate); and
- Ideally, each entity should have its own website and phone number.
- Entities should consider and implement the steps listed in sections i-v above before doing business or entering a transaction, not sometime in the future after the fact. Many of these steps seem to impose time and effort which slows down business deals, and owners may want to skip the step or defer it “until it is needed.” Documenting meetings and transactions and properly recording corporate formation at the outset is the key to helping owners avoid “veil piercing” and owner personal liability. If the steps are taken after the fact, they can be construed to be part of fraudulent conduct and used as evidence to pierce the veil.
- Have bylaws for a corporation or an operating agreement for an LLC and follow the provisions of the bylaws and operating agreement in operating the business;
There is also something known as “reverse piercing” which is an attempt to make an entity liable for an owner’s personal debts. This is rare and not allowed in all states but will be allowed in cases where the entity is used as a fraud. The two most frequent situations are: (a) a subsidiary is a complete shell of a company and controlled solely for the benefit of the parent organization without ever operating as a separate entity; and (b) an individual with enormous unpaid debts seemingly owns a small portion of a profitable business, which does not pay him a salary and owns the assets used by the debtor in his day to day life (city house, farmhouse, beach house and multiple cars) – so it appears he owns nothing but the clothes on his back. In these types of cases, courts in many states will allow a creditor to reach the otherwise protected assets of the entity to satisfy the debts of the “impoverished” debtor.
We are frequently called upon, as lawyers, to give clients hard and fast statements about when a corporate veil will be pierced and the precise steps needed to avoid piercing. We cannot give you bright-line or never-fail rules because facts and circumstances matter in corporate veil piercing claims. But if “corporate formalities” are followed carefully, entities are adequately capitalized and respected as separate entities, and not as the owner’s personal “piggy bank”, corporations, LLCs, and their owners will have gone a long way in protecting themselves from a successful claim of veil piercing.
We are frequently called upon, as lawyers, to give clients hard and fast statements about when a corporate veil will be pierced and the precise steps needed to avoid piercing. We cannot give you bright-line or never-fail rules because facts and circumstances matter in corporate veil piercing claims. But if “corporate formalities” are followed carefully, entities are adequately capitalized and respected as separate entities, and not as the owner’s personal “piggy bank”, corporations, LLCs, and their owners will have gone a long way in protecting themselves from a successful claim of veil piercing.
Let Selzer Gurvitch help you.
Patrick Kearney and the attorneys at Selzer Gurvitch are available to answer your questions about veil piercing and the proper operation of a corporation or LLC to minimize their owners’ risk of personal liability for corporate debts.
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Patrick J. Kearney, Esq.
Partner at Selzer Gurvitch pkearney@sgrwlaw.com
(301) 634-3114 |
About Selzer Gurvitch
Selzer Gurvitch Rabin Wertheimer & Polott, P.C. is a Bethesda, MD law firm focusing its practice primarily on transactional business, real estate, tax, estate planning, and commercial and construction litigation. For more than 39 years, the firm has served clients throughout the Washington, D.C. metropolitan area. Our lawyers apply traditional values of honesty, integrity, and hard work on behalf of our clients. We ask the right questions, listen carefully to the answers, and collaborate to develop and execute strategies designed to cost-effectively achieve our clients’ legal, business, estate planning, and personal objectives. Our attorneys get to know and come to care deeply about the people, businesses, and organizations that put their faith in us. We take tremendous pride in having established many multi-generational client relationships, in which we have earned the same level of trust from those young adults whose parents and grandparents first retained us. Each client, whether new or long-standing, receives our total dedication and commitment to achieve the best possible outcome. At Selzer Gurvitch, we will always stand for resolve, relationships, and results.
[i] The term “corporate veil” is used interchangeably with corporations, LLCs, and limited partnerships, even though the latter two types of entities are not “corporations.” Limited Partnerships are not discussed in this article because they have become rarely used as a tool since the advent of the LLC. However, the same rules apply to that type of entity as apply to a corporation or LLC.
[ii]Ramlall v. MobilePro Corp., 202 Md. App. 20, 32 (2011)
[iii] Fireman’s Fund Ins. Co. v. Fed. Fire Prot. Corp., No. CV SAG-18-1962, 2020 WL 978669, at *3 (D. Md. Feb. 28, 2020)
[iv] Estate of Raleigh v. Mitchell, 947 A.2d 464, 470 (D.C. 2008)(citations internal quotation marks omitted)
[v][v] O’Hazza v. Exec. Credit Corp., 246 Va. 111, 115, 431 S.E.2d 318, 320–21 (1993)(citations omitted)
[vi] Bazarian Int’l Fin. Assocs., LLC v. Desarrollos Hotelco, C.A., 342 F. Supp. 3d 1, 12 (D.D.C. 2018), appeal dismissed sub nom. Bazarian Int’l Fin. Assocs., LLC v. Desarrollos Hotelco Corp. Dhc Aruba, N.V., No. 18-7173, 2019 WL 4565638 (D.C. Cir. Sept. 9, 2019)(internal quotation marks and citations omitted)
[vii] Church Joint Venture, L.P. v. Blasingame, 947 F.3d 925, 931 (6th Cir. 2020)
Disclaimer: The information contained in this material is not intended to be considered legal advice and should not be acted upon as such. Because of the generality of this material, the information provided may not be applicable in all situations and should not be acted upon without legal advice based on specific factual circumstances.