Setting up your business as a corporation generally has the advantage of shielding individual officers, directors and shareholders from liability for business losses and debts. The corporation has its own credit rating and contracts are signed on the corporation’s behalf, not the founder’s. That means the corporation’s debts and losses are attributed directly to the company.
This is one of the main reasons people go to the effort of setting up a corporate structure for their businesses. However, there are rare situations where this limitation on liability will not be effective. When a court finds that a corporation is merely the alter-ego of its shareholders or the formal corporate structure is merely being used to defraud someone, it can “pierce the corporate veil.”
When is piercing the corporate veil a possibility? There are five main situations:
- The company fails to follow essential corporate governance rules
- To further a specific government goal, like regulatory compliance
- To remedy fraud by the corporation
- If the corporate form is merely being used to promote fraud, injustice or illegality
- If the shareholders disregard the corporate form during bankruptcy
Assuming the corporation, or its officers and directors, are not engaging in fraud or other illegalities, the most common reason the corporate veil might be pierced is that the operators of the business have not been following the basic rules of corporate governance. Those rules include, for example:
- Issuing stock and making rules about stock ownership
- Setting up a board of directors and appointing corporate officers
- Drafting articles of incorporation and a shareholders agreement
- Drafting bylaws
- Holding meetings of the board of directors at least annually and keeping meeting minutes
- Publishing an annual report and publishing it with regulators
- Engaging in corporate bookkeeping and audits
When a corporation does not routinely hold board meetings, has no stock or is undercapitalized, a court might determine that is not a corporation at all. If that happens, the shareholders themselves could be financially responsible for debts and losses that they thought were being accrued by the corporation.
If you are a founder/shareholder of a corporation, be sure your corporate veil is never pierced. Discuss how to properly operate your corporation with a business attorney.