By: Tyler Miller

Nearly every entrepreneur understands that it’s important to form a separate legal entity for conducting their business. Regardless of which type of entity they choose to form (e.g., C-corp, S-corp, LLC), one of the primary benefits they hope to derive from their decision is a limitation of liability. By conducting their business through this newly formed entity, they create what’s called a “liability shield,” protecting the founders in their personal capacity from being responsible for the debts and obligations of the company. If the company cannot make good on its promises or commits a tort against someone, the other party can only go after the assets of the company itself – not the individual (typically).

However, what some entrepreneurs may not understand is that this liability shield is by no means guaranteed. Courts generally examine liability shield questions by looking to substance over form, i.e., determining the facts in the real world rather than what the facts are on paper.  Thus, under limited circumstances, courts can “pierce the corporate veil” and hold individuals personally responsible for the liabilities of the company.

The legal doctrine of corporate veil piercing is equitable in nature, i.e., concerned with fairness, and has developed in response to business owners using their separate legal entities as artifices to avoid liability where it otherwise should have existed. See e.g., Medi-Tec of Egypt Corp. v. Bausch & Lomb Surgical, 2004 Del. Ch. LEXIS 21 (Ch. Mar. 4, 2004). Courts look for a variety of factors in making this determination, including whether there is a meaningful distinction between the financial affairs of the business and those of the owner and whether the company’s actions were fraudulent or illegal.

While the specific requirements depend on the state in which the entity was formed, the general guidelines for avoiding veil piercing are well established. Nevertheless, I will focus on the best practices for Delaware organizations since they are the most common. First, it is critical that the entrepreneur adhere to the necessary corporate formalities. This means holding official meetings of the board of directors, shareholders, or members as required, even if the board simply consists of your family and you came to your decision via text message. It is also important to keep detailed records, or “minutes,” of any important decisions that have been made so that there is a paper trail. Managing a startup can be incredibly time-consuming, stressful, and chaotic. It’s easy to let such formalities fall on the back-burner or never be observed at all, but their observance helps to demonstrate that your business is more than just yourself under a different name.

To that end, it’s also necessary to avoid commingling any of the business assets with your personal assets. If a court gets the impression that the separate entity is merely your personal piggy-bank, it’s very likely that they will have no qualms about piercing the corporate veil. This can be easily avoided by establishing separate bank accounts for the company and making sure that you don’t pay any business obligations from your personal account. Additionally, you should not cash checks payable to the company into your personal bank account. For small businesses, this is a common and convenient practice, but the entrepreneur should resist the temptation – the risk of veil piercing can significantly overshadow the additional administrative burden.

Finally, when conducting business, the business owner should be clear with their counterparties about the existence of their separate legal entity. Invoices should contain be on the company letterhead to show people who their dealing with. The name of the company should always be accompanied by something to identify the liability shield such as “LLC” or “Inc.” This will alert people to the fact that they are dealing with a company rather than an individual. Additionally, the entrepreneur should make it clear when signing any documents that they are signing on behalf of the company, rather than themselves. All these precautions will go a long way towards keeping your personal assets safe from the debts and obligations of the business.

Ignoring instances of fraud or misconduct, the legal doctrine of veil piercing is narrow but crucial to be aware of as an entrepreneur. The ramifications of veil piercing can be significant, and the steps required to prevent them are slight. Simply being aware of the doctrine is a useful way to maintain the sturdiness of the liability shield. Following the advice laid out above will all but guarantee its protection.