When Are Business Owners Personally Liable for Business Debts?

When Are Business Owners Personally Liable for the Debts of the Business?

When Are Business Owners Personally Liable for the Debts of the Business?

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Many business owners set up their companies as a corporation or other limited liability entity (like an LLC), in part because it allows them to avoid personal liability for the debts of the business.  This protection, however, is not absolute.  In certain circumstances, courts will allow a party to sue the owners of a company personally for the acts of the owner’s entity.  This is known as “piercing the corporate veil.”

What Does It Mean to Pierce the Corporate Veil?

A corporation or LLC has a separate legal existence from those that own it.  As a result, owners are typically not personally liable for the corporation’s debts.  However, the company’s affairs must be kept “separate” from the personal affairs of its shareholders or members.  Where the owners have not done so, there may be grounds for piercing the corporate veil – that is, holding the owners financially responsible for the acts of their corporate entity.

When Will a Court Allow a Plaintiff to Pierce the Corporate Veil?

Generally, a plaintiff seeking to pierce the corporate veil must show that (1) the owners exercised complete domination of the corporation in respect to the transaction attacked; and (2) that such domination was used to commit a fraud or wrong against the plaintiff which resulted in plaintiff’s injury.

The first part of this test requires that the plaintiff prove that the owner used the corporation for his or her personal benefit, beyond using the corporation to shield the owner from liability.  Essentially, the court asks, is the company the “alter ego” of the owners? 

Courts examine several factors in determining whether there are grounds to pierce the corporate veil, including the following:

  • Inadequate capitalization. Did the owners invest enough capital in the business for it to operate as a separate entity? 
  • Failure to comply with corporate formalities. Has the corporation held regular meetings, kept up-to-date corporate books and records, adopted by-laws and observed other corporate formalities?  Are corporate letterheads and titles being used in business dealings?
  • Commingling company assets with personal funds. Does the business have a separate bank account?  Are separate books being kept for the business?  Is the business being used to pay for personal expenses?  To whom are payments being directed?

Note: courts often allow some leeway for smaller businesses concerning corporate formalities, particularly with regard to holding regular meetings.  Larger businesses are typically afforded less leniency.

In addition, courts will look at whether the company’s actions causing the injury were wrongful or fraudulent.  However, the owner’s domination of the company must have resulted in wrongful or inequitable consequences to the party seeking to pierce the corporate veil.  In New York, the fact that a company is owned by one person is not, stranding alone, enough to pierce the corporate veil.

What Is the Effect of Piercing the Corporate Veil?

If a court allows the plaintiff to pierce the corporate veil, owners, members and shareholders are personally liable for the company’s debts.  This allows creditors to use the business owners’ individual assets, such as their homes, bank accounts, investments, and other property.

Conclusion

Business owners that want to protect themselves from liability should consult an attorney consult an attorney for advice on how to maintain strict separation between their business and personal affairs.  An attorney can also draft corporate documents (by-laws, shareholder agreements, etc.) to help shield corporate officers from personal liability.   

For those injured by a company’s actions, it is important to speak with an experienced lawyer regarding the best course of action.

Photo by Damir Kopezhanov on Unsplash

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This Blog is made available by Romano Law PLLC for general informational and educational purposes only, not to provide specific legal advice. By using this Blog you understand that there is no attorney client relationship between you and Romano Law PLLC or any individual contributor. You should consult a licensed professional attorney for individual advice regarding your own situation.

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