By: Brandon Garner
Congratulations! You have successfully set up a small business and have moved into the operational phase. Being the wise and shrewd businessperson that you are, you have set up your business as a Limited Liability Company (LLC) to ensure personal liability protection.
By setting up as an LLC, you understand that having personal liability protection is vital to a smaller business because unfortunately, you are not a “little big business.” You understand that as a small business, you are subject to lower sales, smaller assets, and fewer employees compared to your larger counterparts.
In addition, you know that external forces such as changes in government regulations, tax laws, and labor and interest rates affect a greater percentage of expenses for small businesses than they do for large businesses. All this is to say, that as a small business owner, the window for mistakes or misjudgments can be deadly.
But, setting up your business as an LLC is a silver lining of sorts for a small business owner like yourself. One of the largest advantages of an LLC is that the government views it as a completely separate entity from the business owner. This distinction protects the owner from any personal liability should the business encounter legal troubles in the form of a lawsuit or financial troubles in the form of debt collectors.
With that being said, the limited liability super-power of the LLC has a kryptonite that all small business owners should be aware of, and it’s called “piercing the veil.” But what exactly is “piercing?”
“piercing the veil”
In the most plain terms, “piercing the veil” is what happens any time a court holds a business owner or managing member legally or financially responsible for the company’s actions. The concept of “piercing” can be very confusing but if we focus on the idea behind an entity veil, the meaning of “piercing” becomes more clear. The idea behind the entity veil is to keep any business type that provides limited liability to its owners completely separate from the people who own and manage it.
As briefly mentioned above, keeping the business separate from the owners ensures that the owners’ personal assets can’t be used to satisfy business debts and liabilities. When this veil that keeps things separate is broken, then owners become subject to the liability they were previously protected from.
If this is still a little bit confusing, let’s think about “piercing” another way. Let’s say that there was a village with a giant wall separating and protecting it from a raging river. One day, the curious people of the village begin excavation on the giant wall and accidentally create a giant crack. The wall begins to crack more and more as the river water begins to penetrate. Eventually, the wall breaks completely and the village is flooded. Here, the village represents the owners of limited liability businesses, the wall represents the veil, and the river represents any financial or legal liability.
In our scenario, the wall protected the village until the villagers created a crack that made the wall break and caused the river to flood the village. In “piercing,” the veil protects the owners from liability, but once the owners begin to mess with the veil, it can break and the owner can be held liable now that the veil is gone. But what factors open up a business owner to “piercing?”
Common factors that Open a Business Owner up to “Piercing” and How to Avoid Them
While there is no perfect set of factors that courts use to decide whether to “pierce the veil,” there are some common factors that courts refer to over and over again when analyzing a “piercing” case; commingling assets and failure to ensure adequate business capitalization.
One factor is the commingling of business and personal assets. Commingling may arise when a business owner creates an LLC but fails to create a separate checking account for the business and continues operating out of the same checking account for personal and business affairs. Comingling may even happen when the business accepts payments in the owner’s name or the owner pays personal bills from a business checking account.
The best way to avoid flying afoul of this factor is to make sure you are keeping your business assets separate from the assets of the owners. Have a business checking account and business credit card and only use these for business expenses.
Another factor is the failure to ensure adequate business capitalization. This factor is especially important for small business owners who as previously mentioned struggle to have as much capital as larger businesses. This factor can occur if a court determines that the company didn’t have enough funds to be truly separate from the owner and stand on its own.
To avoid running afoul of this factor it’s extremely important to be honest about the company’s profitability upfront and attempt to borrow funds if possible to ensure the company is adequately capitalized. Being undercapitalized puts creditors at risk and some business owners do this on purpose. Don’t.
Conclusion
As a small business owner, you constantly climb an upward hill to reach success. Unfortunately, the possibility of “piercing the veil” doesn’t make the hill any easier to climb, but hopefully, this post can help you avoid the common “piercing” factors that can land you in hot water.
This post has been reproduced, edited, and updated with the author’s permission. It was originally authored on February 7, 2024, and can be found here.
Sources:
https://www.daleeke.com/blog/2023/03/3-reasons-why-many-small-business-owners-form-llcs/
https://hbr.org/1981/07/a-small-business-is-not-a-little-big-business
https://www.wolterskluwer.com/en/expert-insights/how-to-avoid-piercing-the-corporate-veil
Image Sources:
Image 2: https://brownandblaier.com/blog/startup-llc-c-corporation-simplified/
Image 4: https://www.istockphoto.com/vector/dam-broken-gm1330519247-413909398
Image 5: https://www.clio.com/blog/commingling-funds/
Image 8: https://www.mbm-law.net/insights/importance-of-an-operating-agreement/
