The Corporate Veil

Most people think that once they have incorporated, the "corporate veil"—the legal separation between the company itself and the individuals that own it—ensures their personal protection, automatically removing any personal liability from the individuals involved. While it's true that a corporation provides limited liability to its owners, there are required corporate formalities that must be followed in order to enjoy this protection.

Incorporating your business is only the first step in protecting your personal assets from the creditors of your corporation. Courts can impose liability on individuals for the actions of the corporation in what is known as "piercing the corporate veil." In order to avoid personal liability for debts and other acts of the corporation, you must run your corporation like the distinct entity that it is.

Unlike a proprietorship or a partnership, a corporation is a legal entity separate and distinct from the individuals involved. Generally, it is represented by its directors, officers, employees, and agents, each in their respective capacities, and it is operated for the benefit of its shareholders. In closely-held corporations, the same individuals tend to act in several of those capacities. There is nothing improper about this. However, in situations like these, it is especially important that those individuals maintain clear distinctions among these capacities when they take various actions and keep careful, accurate records of their business dealings.

When could my corporate veil be pierced?

A court may attempt to pierce the corporate veil in instances of criminal activity by an officer, shareholder, or director, or in any situation where the shareholders treat the corporation as an extension of themselves by filtering their personal dealings through the corporate structure.

While it is impossible to tell you all of the corporate formalities you must follow in order to avoid personal liability for debts and other obligations of the corporation, as different courts may choose to apply varying factors in varying degrees, we can give you a solid foundation of information so that you can protect yourself.

Courts often consider many factors in determining whether to pierce the corporate veil. Here are some of the things courts might look for:

  • If the corporation has failed to follow the appropriate corporate formalities (i.e., having and observing the bylaws, minutes of shareholder, and board of directors meetings or actions, etc.);
  • The absence of corporate records;
  • If the major shareholders are siphoning money from the corporation for their personal use (i.e., when a principal shareholder takes money from the corporation to pay a home mortgage or buy gifts for him- or herself, etc.);
  • If there are officers or directors with no function in the company (perhaps put in place by a majority shareholder but not actively involved in the corporation);
  • A comingling of funds and other assets between major shareholders and the corporation;
  • Inadequate capitalization (the corporation is undercapitalized at the time transactions with creditors are entered, or there is simply not enough capitalization to get the corporation running);
  • No corporate assets; and
  • If the corporation has entered into contracts with no intent to make good on the obligations.

How can I keep my corporate veil intact?

To avoid the IRS attempting to pierce the corporate veil, it is essential that minutes be kept of board and shareholder actions. Corporate minutes are the first line of defense against the IRS, creditors, and other parties making claims against the corporation, particularly if a claim is based on a theory that the corporation should not be taxed as a corporation or afforded limited liability (in other words, that the owners should not enjoy the protection of the corporate veil).

Minutes can be either the written record of meetings, or the unanimous written actions of the directors or shareholders taken without a meeting. Either is acceptable, if properly done. Many closely-held corporations fail to keep even annual minutes, which greatly weakens the position of the corporation and its shareholders, directors, and officers in many circumstances.

Keeping regular minutes can also:

  • Prevent IRS claims of unreasonable compensation for executives who are also shareholders;
  • Protect against IRS claims of excess accumulated earnings;
  • Create defenses against lawsuits attempting to establish personal liability of directors or officers by evidencing board business judgment and specific authorization;
  • Protect against spurious lawsuits of minority shareholders; and
  • Establish authority for corporate actions for the benefit of outside parties.

Minutes of a meeting should be prepared by the Secretary of the corporation, signed, and then approved by the board or shareholders, as the case may be, at the next meeting or in the next action. This will minimize any claim that the written minutes do not accurately reflect the action taken. Minutes should always reflect that proper notice was given or waived, who was present and who was absent, and that a quorum was present. Any abstentions or dissents on a vote should be noted for the protection of the director abstaining or dissenting. In a closely-held corporation, meetings are often held only to create minutes rather than to make decisions, but holding formal meetings with parliamentary procedures tends to result in more deliberate and organized decision-making and, if practical, is recommended.

It is equally important that minutes be limited to material that helps and not hurts the corporation. Resolutions should be set forth. The fact that a report was given or a discussion held on a subject should be noted. Statements made by a director or the actual content of a report or discussion, however, should generally not be included, since these references tend to be damaging more often than not. Claimants of a corporation will many times establish their case on the basis of minutes that were too detailed.

It is also important to maintain a climate in which each director feels free to speak his or her mind during a board meeting, secure in the knowledge that their words will be kept strictly confidential and won't later show up in a written record describing the board's deliberations. Generally, only formal resolutions adopted by the board should be set forth in minutes.

It is advisable to review any other detailed descriptions in minutes with legal counsel before completing them. Among others, resolutions should be considered on the following subjects:

  • Compensation of officers;
  • Authorization of important contracts;
  • Acquisition of property;
  • Loans and guarantees;
  • Designation of banks;
  • Engagements of lawyers, accountants, and other professionals;
  • Declaration of dividends;
  • Approval of mergers;
  • Issuance of shares;
  • Sale of assets;
  • Authorization to sign checks, deposit funds, and make withdrawals;
  • Approval of financial statements and audit reports;
  • Compliance with governmental regulations; and
  • Adoption of employee benefit plans.

Corporate minutes are very important—especially when the corporation has dealings with its own officers, shareholders, or directors—to demonstrate that all the transactions are proper. While this is a lot to digest, and there are more things that parent corporations must follow to avoid the corporate veils of their subsidiaries being pierced, make absolutely sure that you NEVER:

  • Comingle your personal assets with those of the corporation;
  • Divert corporate assets for your personal use;
  • Engage in activities with the intent to defraud creditors; or
  • Engage in transactions with officers, directors, or shareholders that are anything but by the book.