Piercing the corporate veil occurs when courts set aside the liability protections of a corporation or limited liability company (“LLC), holding its shareholders, directors or members personally liable for the company’s actions or debts. This undermines one of the primary purposes of creating a corporate structure: shielding individuals and parent companies from financial and legal risks.
In this article, we’ll explore the concept of piercing the corporate veil, its implications for parent companies and subsidiaries and actionable steps to protect your business from this legal exposure.
What Is Piercing the Corporate Veil?
When courts pierce the corporate veil, they disregard the legal distinction between a company and its owners, exposing shareholders or parent entities to personal liability. This typically happens when a plaintiff can prove that a company is being used unjustly or fraudulently to shield wrongful conduct or financial mismanagement.
While the corporate veil is a critical legal protection, it can be vulnerable in cases where:
- A parent company exercises undue control over a subsidiary.
- Companies fail to maintain proper separation of operations, finances, or decision-making.
- Fraud or injustice would occur without piercing the veil.
This issue is most common with privately held businesses or closely related corporate entities, such as parent-subsidiary structures.
When Do Courts Pierce the Corporate Veil?
Courts are more likely to pierce the corporate veil when:
- A parent company dominates the operations of a subsidiary to the extent that the subsidiary lacks independence.
- Plaintiffs demonstrate that failing to pierce the veil would result in fraud or injustice.
The risk increases if companies do not maintain an arm’s-length relationship between parent and subsidiary entities. This refers to a business arrangement where parties operate as separate, independent entities, even if they share ownership. Overlap in resources, employees, or decision-making can blur this distinction, raising the likelihood of veil-piercing.
10 Steps to Prevent Courts From Piercing the Corporate Veil
- Maintain Separate Accounting and Bank Accounts
Each entity should have its own payroll, balance sheets and profit-and-loss statements. Loans between entities should be documented with formal agreements to avoid appearances of impropriety. - Ensure Separate Employees and Payroll
Avoid sharing employees across entities. Each company should manage its own hiring, firing and payroll to demonstrate operational independence. - Maintain Separate Insurance Policies
Each entity should have its own insurance coverage. This demonstrates their distinct legal and operational identities. - Avoid Fraud or Misrepresentation
Courts are more likely to pierce the veil when fraud or deceit is involved. Avoid using subsidiaries to shield wrongful actions or liabilities of the parent company. - Properly Capitalize Subsidiaries
Subsidiaries must have sufficient financial resources to operate independently. Undercapitalized entities may be viewed as sham operations created to funnel resources to the parent company. - Use Contracts to Define Relationships
Draft management service agreements and subcontractor agreements to document shared resources or services between entities. Proper documentation reinforces the separateness of operations. - Separate Boards of Directors and Advisors
Each entity should have its own directors or advisors. This minimizes the perception of centralized control by the parent company. - Maintain Appropriate Debt-to-Equity Ratios
Ensure that subsidiaries have reasonable and industry-standard financial structures. Payments between companies should serve legitimate business purposes. - Create Distinct Brand Identities
Each entity should have its own website, social media accounts, logos, email addresses and marketing materials. Separate branding reinforces their independent operations. - Follow Corporate Formalities and Keep Records
Adhere to all organizational rules outlined in bylaws or operating agreements, such as holding annual meetings, keeping minutes, and maintaining clear ownership records.
What Happens If the Corporate Veil Is Pierced?
If a court pierces the corporate veil, shareholders, members, or the parent company may be held personally liable for the subsidiary’s debts and obligations. This could result in creditors or plaintiffs targeting personal or parent company assets, such as real estate, bank accounts or investments, to satisfy liabilities.
Minimizing the Risk of Veil-Piercing
While the risk of piercing the corporate veil varies by jurisdiction and specific circumstances, it can be greatly reduced by:
- Structuring your entities properly.
- Following corporate formalities.
- Maintaining distinct operations and financial independence for each company.
Consulting with a qualified attorney is essential to ensure that your business complies with corporate governance standards and can withstand challenges to its liability shield. Your lawyer can also help you apply the “arm’s-length” test to guide your practices and identify potential vulnerabilities. By proactively addressing these issues, businesses can protect themselves from personal liability and preserve the integrity of their corporate structure.
