Limited Liability Protection and Piercing of the Corporate Veil

What is the “Corporate Veil”?

When a business entity is formed, it gains a legal existence distinct from its owners. As a business takes out loans, enters into contracts, has customers on its premises, etc., it becomes exposed to potential liability. The business cannot escape liability for its own activities. However, as a general rule, its owners will not be held personally responsible for business acts, debts, or obligations. That is, the owners’ personal assets may not be used to satisfy business liabilities or legal judgments against the business. This liability shield is known as the “corporate veil.”

The owners of certain types of business entities receive this liability shield by law upon business formation. The relevant Kentucky statutes include KRS 271B.6-220(2) (for corporations), KRS 275.150(1) (for LLCs), and KRS 362.1-306(3) (for LLPs). This protection is the main reason most individuals form a business entity in the first place.

The “corporate veil” is somewhat of a misnomer in that it does not apply exclusively to corporations. The limited liability protection provided by other entity types may be challenged under the same legal doctrine. See, e.g., Rednour Properties, LLC v. Spangler Roof Services, LLC, 2009-CA-001159-MR 06/10/2011, to be published.

What Does it Mean to “Pierce the Corporate Veil”?

Piercing the corporate veil is the legal process whereby a court disregards the usual immunity given to business owners and holds them personally liable for wrongful business activities. The term is meant to suggest that the corporate (or LLC, LLP, etc.) existence is a sham and the court should uncover the corporate disguise to reveal the individuals truly responsible for the corporate misdeeds.

Courts are reluctant to pierce the corporate veil because personal liability protection is clearly intended by statute. However, it will be done if warranted under the circumstances. “When a separate legal entity is used to justify wrong, protect fraud, or subvert public policy, then the corporate veil should be pierced and the association of persons making up the corporation should be held responsible for the corporation’s financial liabilities.” United States v. WRW Corp., 778 F. Supp. 919, 922 (E.D. Ky. 1991). When a corporate veil is pierced, the business is treated as a Sole Proprietorship (if a single owner) or a General Partnership (if multiple owners), neither of which offers any level of personal liability protection. See KRS 362.1-306(1).

Why Might the Corporate Veil Be Pierced?

Kentucky recognizes three separate theories that may justify piercing the corporate veil. They are the Instrumentality Theory, the Alter Ego Theory, and the Equity Formulation Theory. White v. Winchester Land Development Corp., 584 S.W.2d 56, 61 (Ky. Ct. App. 1979).

Instrumentality Theory
To warrant piercing the corporate veil under the instrumentality theory, it must be shown that:

  1. The corporation was a mere instrumentality of the shareholder;
  2. The shareholder exercised control over the corporation in such a way as to defraud or harm the plaintiff; and
  3. The refusal to disregard the corporate entity would subject the plaintiff to unjust loss.

Alter Ego Theory
To warrant piercing the corporate veil under the alter ego theory, it must be shown that:

  1. The corporation is not only influenced by the owners, but also there is such unity of ownership and interest that the separate personalities of the corporation and its owner cease to exist; and
  2. The facts are such that an adherence to normal attributes, such as treatment of the corporation as a separate entity, and of separate corporate existence would sanction a fraud or promote injustice.

Equity Formulation Theory
To warrant piercing the corporate veil under the equity formulation theory, a court will consider whether:

  1. The corporation was undercapitalized;
  2. The corporation failed to observe the formalities of corporate existence;
  3. The corporation did not pay or overpaid dividends;
  4. The dominant shareholder(s) siphoned off funds from the corporation; and
  5. Majority shareholders guaranteed corporate liabilities in their individual capacities.

A common element of each theory is the presence of fraud. Courts will be willing to hold individual owners liable if the corporate persona has been knowingly used to defraud others and the corporate owners seek to avoid a liability that they would not be able to avoid if the corporation did not exist.

General Recommendations to Avoid a Piercing

Avoid Mixing Individual and Corporate Funds
If assets are “comingled”, it suggests that the business entity is merely the extension of its owner’s personal financial accounts. To avoid this appearance, owners should:

  1. Set up a separate business bank account and make all business-related payments through that account.
  2. Avoid writing personal checks for business matters and accepting checks in their personal names.
  3. Not enter into contracts for the business in their individual capacities. When signing contracts, owners should make their position/title in the business evident.
  4. Avoid mixing assets of one business with that of another, especially those that carry on the same or similar business activities with the same or similar participants.

Maintain Adequate Capitalization
A business is expected to maintain adequate funds to pay its regular and foreseeable debts and obligations as they come due. The amount of capitalization that may be required depends on size of the business, the number and value of its liabilities, the common practices of the industry, etc. at minimum, a business should:

  1. Always maintain enough capital to pay recurring bills, salaries, and other obligations.
  2. Pay creditors before distributing profits to owners. A court will likely require owners to repay any improperly received distributions anyway. See KRS 271B.6-400(3).
  3. Carry adequate insurance to cover possible suits and judgments, given the nature of the business activities.

Observe Entity Formalities
The relevant Kentucky business entity statutes set forth the minimum operational formalities that business owners and managers must observe. Corporations are expected to observe the most such procedures, while LLCs and LLPs may conduct business affairs more informally. In all cases, business owners should:

  1. Adopt a business governing document (Bylaws, Operating Agreement, etc.) specific to the business that reflects the owners’ expectations as to how the business should be run. It should outline the required formalities in a way that the business owners and managers will be able to follow. Update it as necessary.
  2. Follow the business’ established procedures for voting on/consenting to business-related matters. Provide adequate notice to all owners entitled to participate in the decision-making process.
  3. Keep all required books and records at a main business office (for at least 4 years) and allow them to be inspected upon request.
  4. File the business’ annual report with the Secretary of State to remain in good standing.
  5. Maintain a registered agent in Kentucky. File changes to the business’ registered agent, registered office, or principal office, as necessary.
  6. Update the business formation document (Articles of Incorporation, Articles of Organization, etc.) when there has been a significant change in the business.
  7. If the business must dissolve, do so in accordance with Kentucky law. Failure to properly terminate the business may cause courts to view it as still in existence, meaning liabilities may continue to accrue.

Takeaway Points

The corporate veil/liability shield will protect business owners from personal liability for business debts in most instances. However, the law takes the position that if the owners do not act as if the business exists – whether by commingling funds, failing to adequately capitalize, or ignoring basic business formalities – the owners should not be entitled to its liability protection. By their nature, small businesses are more at risk: there are fewer owners and managers so it appears more as if the business is an extension of its individual participants, less capital is retained within the business because there are less revenues, and its owners may be less experienced with running a business and keeping up with required organizational formalities.

Fortunately, business owners avoid having their entity’s corporate veil pierced by taking steps that they should be doing anyway: utilizing a separate business bank account, paying bills as they come due, filing relevant changes with the Kentucky Secretary of State, etc. Business owners should keep adequate written evidence that such steps were taken to defend against a possible request to pierce the corporate veil.