Piercing The Corporate Veil

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A question I see pop up in many industry forums, especially among smaller businesses (i.e. home based) owners is the question that goes along the lines of “should I get insurance or should I create an LLC?”

For purposes of this article and within this context, I’m thinking a Limited Liability Company (LLC) and Corporation are the same. With the objective of limiting the shareholder/owner/officers liability to the amount invested in case things don’t work out as well as hoped.

Also, for purposes of this article, and this site generally speaking, it’s highly important for you to know, understand, and agree that the writer is an insurance agent and not an attorney, much less an attorney in the state where you’re most likely reading this from. In other words, my business card says “insurance agent” and it does not say “attorney at law.” Furthermore, what I write about is generally applicable to jurisdictions I’m licensed in, and may not be correct in the state you’re located. So the best advice is as always, talk to a qualified legal adviser who focuses on business litigation and issues before making any decisions.

Am I allowed to write about legal matters? Sure, under two theories. First, I have the First Amendment right to publish my thoughts, which provides people with a pretty wide berth to work with. Secondly, I’m an insurance agent/broker, and my focus is on insurance matters, which naturally is going to touch on legal issues, and I’m allowed to discuss insurance issues, including those that naturally are incidentally legal issues.

Ok, now that I have the CYA out of the way, lets us move back towards the idea of using an LLC to protect you from a lawsuit going after you personally.

It’s actually pretty easy to push people off the “I’ll setup an LLC instead of insurance argument with a question to answer the question.”

If your LLC gets sued, do you think the plaintiff will name you as a defendant as well? Believe it or not, I do sometimes have people respond with and I’m paraphrasing here for clarity and ease of reading,… “they can’t name me because I’m the owner and it was a LLC the plaintiff had a contract with, or it was the LLC that caused the damage.”

To wit, I respond with who or what is actually going to stop them from naming you?

Now, there’s more to it than that. For example, if the owner is also the person who caused the damage (i.e. the driver in the accident), which with small businesses, is often the case (not the driver part, the part of the owner was the person who caused the controversy the lawsuit is based on).

My point is, EVERYONE the plaintiff’s attorney can think of that may have something to do with the issue is likely to get named. It’s then up to each defendant to demonstrate they don’t have any personal liability before they get a “get out of jail free card” and can walk away. Just the process of proving no liability can cost thousands of dollars in attorney fees unless you’re ready to go into court yourself and using the rules of civil procedure and evidence to convince a judge the attorney is wrong and you’re right in the fact you don’t belong on the defendant’s list.

Ok, maybe a little off point strictly speaking in terms of piercing the corporate veil, albeit for many defendants without insurance, it’s a complete financial disaster well before you get to that place of trying to defend the veil.

Plus, once you read about the criteria that may be used to pierce the corporate veil, it will become increasingly obvious why I wrote the above first, and why it may matter more than if the veil can be pierced independently or not.

I also want to clear up something really quick too. It’s a mistake I actually made myself many years ago and before I started 1 Reason Insurance. If you own a home, or have a renters insurance policy, your insurance likely (almost all do) has liability coverage in case you get sued. That coverage, almost NEVER covers any lawsuit related to a business activity. Most homeowner/renter insurance policies have an exclusion for “business pursuits” or language of exclusion that is something similar meaning essentially the same thing. In other words, your home based business and what goes on because of it, isn’t covered by a standard homeowners/renters insurance policy. Some policies have endorsements that may be added to provide coverage, and that’s where having a conversation with your insurance agent is a good idea. “Hi, I’m running a business in my home, is there anything I need to know about insurance?” is a VERY good place to start so you don’t have surprises afterwards.

With all that said, let’s go into fantasy land for a moment and assume your business was sued, it’s an LLC, and for whatever reason, you weren’t named, albeit the plaintiff wants to hold you personally liable and the only way they can think of is by piercing the corporate veil. I think we’re really in lala land, but it keeps the focus tight.

Two types of plaintiffs. The first is tort creditors and the second is contract creditors. Tort is latin for twisted, as in the act was twisted and wrong. For example, you throw a hammer at someone joking around and it hits them in the head. They file suit against you to medical and lost wages. That type of suit is a tort lawsuit. There’s more to it than that, and I’m oversimplifying because this is about insurance not law, but for more detail you can ask Google, attorneys, or a law website.

Contracts are easier to understand as it’s a promise and you failed and the other party is suing you. Insurance can provide coverage in case you’re not able to complete a contract you promised to perform. That type of coverage comes from a surety bond. For example, we have contractor performance bonds available and they’re rather straight forward in concept.

If you as a contractor fail to perform, the bond pays out whatever it costs the other party to get performance over and above what the agreed upon contract states it should cost. Government work often requires contractor performance bonds.

As a general rule, and I need to stress this is a starting point, not the finish line if you’re really wanting go to know the nuances of piercing the corporate veil in your state, it’s easier to pierce over a tort claim than it is for a contract claim.

I think this is in part because the other party voluntarily choose to become a counterparty, while a person injured (and injury can mean money or physical in this context) didn’t have the opportunity to decide to have damages by any given person.

Often Contract plaintiffs will be required to show at least two key factors below, while tort plaintiffs only have to demonstrate one key factor below to pierce the corporate veil.

The key factors include the following failures by the LLC:

1. The LLC form and purpose was used to commit fraud or dishonesty.
   1. This should be pretty easy to wrap your head around. If all it took to avoid personal responsibility for illegal acts, including fraud, then more people would setup LLCs to steal with.
2. Alter Ego
   1. When an LLC has been so utilized by its owners that no separate entity has been maintained and the LLC is merely an alter ego of the owners.
3. LLC / Corporation dominated/controlled by one individual or another LLC/ Corporation.
   1. Somewhat similar to Alter Ego, …. has the individual or another entity miled the LLC of its money and capital, causing the LLC an inability from accumulating capital to meet expanding business needs as it grows.
4. Commingling of corporate assets and shareholders personal assets.
   1. This is one I see happen with a lot of really small (and sometimes not so small) companies. Using company credit cards/debit cards to pay personal expenses comes to mind. Pulling money out of an ATM from a business account to have money for food and beverages is a top cause of this one too.
5. Corporation / LLC undercapitalized
   1. An entity is often considered inadequately capitalized when its shareholders have not invested enough capital to meet the entity’s prospective business risks and obligations that one could reasonably be expected to arise in that business entity at the time of the entity’s formation/start.
   2. This is a big one when it comes to the question of “should I form an LLC or buy insurance.” If your purpose of creating an LLC was to avoid having reasonable insurance and/or enough business capital to meet possible and reasonable liabilities, you should expect you’re personally on the hook if you’re also a managing officer of the LLC. You just can not expect things to end well if you’re sued and hoping the LLC was a better alternative to having insurance.
6. Basic corporate formalities were not followed.
   1. I don’t know this, however, I suspect that because LLC’s are generally easier to maintain formalities simply because there are fewer to follow, this isn’t nearly as big of a factor for LLCs as it is for corporations. Still, LLCs do have some formalities that are required, and it’s a good idea to stay within the rules so this isn’t an issue for you.

There’s also another “gottcha” you may want to know about. It’s called the “Enterprise Liability Theory” – and it goes along these lines. Affiliated corporations are considered fragments of one business enterprise where the subsidiary is wholly owned by the parent.

A Creditor may reach assets of Corporation B if the same shareholders own stock of both corporations and both engage in the same business. This isn’t the same as piercing the corporate veil. With Enterprise Liability Theory, the liability is imposed on the other closely connected corporations.

Where I’m concerned as an insurance agent with the Enterprise Liability Theory derives from landlords placing rentals into separate LLCs. As in each property has its own LLC as an owner, which is then owned by the person in control of the rental properties. I have no experience seeing a landlord having to protect against an Enterprise Liability Theory claim, albeit it’s one I intend to look into further as time permits.

Going back to piercing the corporate veil, we can see that as your insurance agent, I’m concerned with the six factors listed above and so while it may appear self-serving to say you should have insurance instead of an LLC before having an LLC instead of insurance from a liability perspective, it doesn’t change the fact I’m right about it. And now you know why I feel that way.

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