Question: I have heard the term “piercing the veil” of a corporation or a limited liability company. What does the term mean and why do owners of LLCs need to understand it?
Answer: “Piercing the veil” means that a court disregards the shield or veil created by state law that says the owners of a corporation or an LLC are not liable for the debts of the entity.
Example 1: Homer Simpson’s LLC called World Wide Widgets, LLC, borrowed $25,000 from Ned Flanders. The LLC signed the promissory note, but Homer didn’t. The LLC does not pay. World Wide Widgets, LLC, doesn’t have any assets so Ned knows if he gets a judgment against the LLC he can’t collect it. Ned never gets his money.
Example 2: Same facts as Example 1, but in operating the LLC Homer did not follow Arizona LLC law and did not follow proper procedures. Ned sues the LLC and Homer and asks the court to pierce the veil and hold Homer liable for the LLC’s debt. The court finds there are grounds to pierce the company veil and holds Homer personally liable for the LLC’s $25,000 debt. This is the bad result for the LLC member and frustrates the reason people form an LLC, i.e., to protect themselves from liability for the debts of the LLC.
Jay Adkisson, a nationally known asset protection lawyer, said the following in response to a recent court ruling in a case called Shermane Hector v. Mo–Dad Environmental Serv., LLC:
The veil-piercing/alter ego challenges to LLCs are going to be interesting because they start out with the intended lack of formality of corporations, and then their owners often get loosey-goosey about how the company is operated, how it is capitalized (and continues to be capitalized), etc. IMHO, the real challenge for planners is not so much in the meticulous drafting of LLC management agreements and the like, but in the education of owners as to how the entity needs to be run after all the ink dries.
How true. The vast majority of people think that if they file the Arizona Corporation Commission’s fill in the blanks form Articles of Organization they are home free and their life savings are protected from the LLC’s debts. Ignorance may be bliss, but ignorance of the legal concept called “piercing the company veil” can cost LLC members big bucks.
Most people who form an LLC don’t know that they must comply with Arizona’s LLC law or risk a court piercing the veil and holding them liable for the LLCs debts. For example, Arizona LLC law requires that every Arizona LLC maintain certain records. If you own an Arizona LLC don’t you think it would be a good idea to comply not only with that statute, but other Arizona LLC laws too?
The Shermane Hector v. Mo–Dad Environmental Serv., LLC court said this about veil piercing:
Some of the relevant factors considered in determining whether to apply the alter ego doctrine include: commingling of corporate and shareholder funds; failing to follow statutory formalities for incorporating and transacting corporate affairs; undercapitalization; failing to maintain separate bank accounts and bookkeeping records; and failing to hold regular shareholder and director meetings”
In forming 6,700+ Arizona LLCs I learned a long time ago that I must educate my LLC clients about Arizona LLC law. I accomplish this two ways:
- The LLC Operations Manual: This is a 170 page book I wrote that explains Arizona’s LLC law in great detail. For example, chapter 3 of the Operations Manual contains a list of 34 tasks that every LLC should complete in its first 75 days. Learn more about the LLC Operations Manual.
- Informative Email Messages: Everybody who hires me to form an Arizona LLC will be sent 50 email messages during the first year informing them about Arizona LLC law and reminding them to do things like sign the Operating Agreement, open a bank account, set up the LLC’s bookkeeping system, consult with a CPA and document loans by members to the LLC.
To learn more about this very important topic read my article called “Two Phases in the Life of an LLC.”