The LLC is an extremely popular entity type, especially for small businesses. And it’s no surprise why: the LLC offers a lot of flexibility and a corporate veil.
Not sure what a corporate veil is? Don’t worry–this guide has you covered. We’ll discuss what the corporate veil is as well as piercing the corporate veil.
What is the Corporate Veil?
A corporate veil is a legal division between the entity itself and the entity’s owners. It is a unique feature of incorporated entities, including both LLCs and corporations. Thanks to the veil, the personal assets of the LLC’s owners are protected. This veil means that creditors or investors cannot claim your house or car if your LLC defaults on a loan or another obligation.
However, the veil is not all-powerful. If your business is not completely compliant, the veil can be pierced. If the veil is pierced, the personal liability protection no longer exists.
What Happens When the Corporate Veil is “Pierced?”
A veil is pierced when a court rules that the LLC’s actions have forfeited the owners’ personal asset protection. That’s why a non-compliant corporation can sometimes slip under the legal radar: only when the business is brought to court (usually by a disgruntled creditor or plaintiff) is the veil officially pierced.
The veil can be pierced under several circumstances. For one, if your LLC does not adhere to the corporate formalities required of LLCs, you could jeopardize your veil. Thankfully, the list of formalities for an LLC is far shorter than those of a corporation. Usually, you’ll need to submit your annual report on time, keep your licenses up to date, maintain financial records, pay any necessary taxes, and fulfill any requirements unique to your state.
The veil can also be pierced if there is no division between the finances of the LLC itself and the business’s owners. This occurs most often with small, single-member LLCs, where the bank accounts for the business are held exclusively by one person. If the owner uses the LLC’s funds for personal, private affairs or vice versa, the corporate veil is pierced.
Understandably, the court may also rule for a veil piercing if the company commits fraud. Not every case of fraud actually traces back to the LLC’s owners (especially in big entities). That said, if the court determines that the owners are either responsible for or liable for the fraud, the veil is pierced.
Finally, a court can rule that the owners are personally liable if the LLC did not have enough starting capital to survive in the first place. Please note that these are all factors in a court’s decision; the severity and number of offenses will ultimately affect the decision.
For example, you won’t be personally liable for failing to file one annual report. But if you skipped multiple annual reports and mixed your personal and business accounts, your veil could be compromised.
How Can I Protect My Corporate Veil?
Smaller LLCs are more likely to lose their corporate veil. The lower accountability and smaller staff makes them more prone to overlooking requirements. Fortunately, with intentional, good business practices, you can protect your veil.
There are four steps to keep your veil in tact:
1) Follow all corporate formalities for LLCs.
Paperwork is a hassle, but it’s a vital part of operating your LLC. You’ll want to find some way to remind yourself when a form is due. This is especially important for your annual reports and business licenses.
Some states will actually send you a reminder when your annual report is due. If you use your state’s online portal, you can also usually find your due dates all in one place. You can also set up reminders in your own business calendar, too. The way you remind yourself of due dates is not as important as meeting them.
2) Maintain an accurate record of your business transactions.
Keeping good financial records helps you in several ways. For one, you can present your record as evidence if you’re ever audited by the IRS. Some states also request a copy of your financial records for the year as part of your annual report.
Multi-member LLCs need good records to protect themselves from fraud. If you track your transactions carefully, you’ll be more likely to catch discrepancies. Plus, the record helps you’ll know exactly what your bottom line is and how much profit can go to the members.
3) Keep personal finances separate from business finances.
Most small LLCs get into trouble because their personal finances are indistinguishable from the LLC’s. Fortunately, you can take a few steps to separate the books. The most important one is to get a separate business bank account. You should also get checks and a card in the name of the LLC.
If your business bank account and your personal account are held at the same bank, it’s possible that your cards look pretty similar. It’s a good idea to customize one card so they’re easy to distinguish. There’s usually a small fee. But it’ll be worth it to avoid the hassle of correcting transactions when you use the wrong card.
Similarly, when you sign checks or agreements for your business, you’ll need to note that the business is guaranteeing the document, not you personally. You can do so by adding your title and the LLC’s name underneath the signature. For example, signing “Joe Smith” with “Owner, Best Tree Guys, LLC” underneath makes it clear that this is a business endorsement, not a personal one.
Never pay bills for the business from your personal account or vice versa. Of course, you do need to “pay” yourself to make your work worthwhile. To give some of the profits back to yourself without mixing the books, you can send a distribution to yourself (or however many members your LLC has). This “transfers” the funds from the business to your personal account compliantly.
4) Start out with adequate funds.
When you’re starting out, make sure you have enough capital to get the business going. Any start-up entails some financial risk, but appropriate financial planning increases your chance of success. It also makes you more attractive to new investors.
If a court decides that your initial capital was insufficient, then your personal assets could take the hit to make up for it.
A corporate veil makes incorporating as an LLC worth your while. However, it’s your responsibility to maintain that veil by operating a compliant business. That way, you’ll always have the personal liability protection. You’ll have peace of mind that your own hard-earned assets are protected.