Incorporator The Journal of U.S. Formation
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Editorial 6 MIN READ

The formalities that keep your LLC from becoming you

What veil piercing actually looks like, and the unglamorous hygiene that prevents it

The Editors
Staff, Incorporator.org
6 min read Updated
Contents 7 sections
  1. What veil piercing actually is
  2. The factors, in the order they come up
  3. The hygiene, in the order it matters
  4. Single-member LLCs get extra scrutiny
  5. Capital accounts and insurance
  6. The rule of thumb
  7. Sources

n LLC is a liability shield until a judge decides it isn't. Maintaining separate entity formality is the daily practice of making sure that decision, if it ever comes, lands in your favor.

Most founders treat the operating agreement as a one-time birth certificate and the bank account as a convenience. That is the posture courts use to pierce the veil.

What veil piercing actually is

Veil piercing is the common-law exception to limited liability. Creditors who cannot collect from the entity ask a court to reach the owner personally on the theory that the entity was not really separate.

The canonical case is Walkovszky v. Carlton, 18 N.Y.2d 414 (N.Y. 1966), where a taxi passenger tried to reach the owner of a fleet split into ten two-cab companies, each carrying minimum insurance. The Court of Appeals declined to pierce on the pleadings as framed, but the opinion set the template: a corporation that is a "dummy" for the shareholder's personal business, or that has been intentionally undercapitalized to defraud creditors, loses its shield.

The federal version most often cited is Sea-Land Services, Inc. v. Pepper Source, 941 F.2d 519 (7th Cir. 1991). A shipping creditor sued an empty-shell customer and then pursued its sole shareholder and his other entities. Judge Easterbrook laid out the two-prong test many jurisdictions now use in substance: first, such unity of interest that the separate personalities of the entity and its owner no longer exist (alter ego), and second, that observing the fiction would "sanction a fraud or promote injustice." The facts the Seventh Circuit accepted on the first prong read like a checklist of what not to do.

The counter-example is Radaszewski v. Telecom Corp., 981 F.2d 305 (8th Cir. 1992). A tort plaintiff tried to pierce to a parent whose subsidiary had gone insolvent after the accident. The Eighth Circuit, applying Missouri law, refused. The subsidiary had carried substantial liability insurance adequate to the underlying risk. Financial responsibility, the court said, can be insurance. Capitalization is measured against the risk profile, not a generic balance-sheet minimum.

The factors, in the order they come up

Undercapitalization at formation is first because it is the hardest to fix later. The question is whether, on the day you formed it, you put in enough capital (equity, insurance, or both) to meet the reasonably foreseeable obligations of the business you were actually running. A consulting LLC with $500 and a laptop is usually fine. A construction LLC with the same $500 and a forty-story project is not.

Commingling is second because it is the easiest to catch. If the LLC pays the owner's mortgage, or the owner's personal card buys inventory the LLC later sells, the plaintiff's forensic accountant will produce a chart. Commingling is how alter ego gets proven in discovery without anyone having to argue theory.

No corporate records is third. LLCs have fewer statutory formalities than corporations by design, and many states say the absence of meetings is not, by itself, a ground for piercing an LLC. Delaware's 6 Del. C. § 18-1101 codifies that policy. But a court looking at an alter-ego claim will notice that the LLC never papered a single major decision, never adopted an operating agreement, and cannot produce a capital account. "We didn't have to" is legally correct and practically insufficient.

Alter ego is the overall characterization, where the first three factors get weighed. A plaintiff who can show commingling, inadequate capital, and no records, and who can tell a story in which the defendant used the entity to evade an obligation, usually wins.

The hygiene, in the order it matters

Most of what follows costs less than an hour a quarter.

Open a separate bank account the day the EIN arrives, and do not run personal expenses through it. If the owner needs money from the business, that is a distribution, a loan, or a guaranteed payment, and it is recorded as such. If the business needs money from the owner, that is a capital contribution or a loan. The test is whether a CPA looking at the books six years from now could tell which is which without calling you.

Get a separate credit card in the entity's name, paid from the entity's account. Not an authorized-user card on your personal account. If the business is too new to qualify on its own credit, personally guarantee an entity card; that is a documented transaction.

Sign a separate lease where the business has physical presence. A home office is fine, but if the LLC uses space, it should pay rent under a written arms-length agreement at a defensible rate. The IRS cares about this for deductions; a piercing plaintiff cares about it for alter-ego purposes. The same document answers both.

Do not reimburse personal spending without documentation. Expense reports with receipts, dated and described, posted through the accounting system, paid by the entity to the owner. "I'll Venmo myself for the client dinner" is how the commingling chart gets its first entry.

Hold annual meetings and keep minutes even as a sole member. The meeting takes ten minutes and the minutes are a one-page document ratifying the year's major actions, approving distributions, and noting the election of officers or managers. What the court sees in discovery is either a folder of minutes or an empty folder.

Use written consents for major actions between meetings: taking on debt, signing a lease, admitting a member, issuing profits interests, amending the operating agreement. Each is a one-page consent, signed, dated, filed.

Draft arms-length intercompany contracts when you operate multiple entities. A holding LLC providing management services to three operating subsidiaries should have a management services agreement with each, at a defensible rate, invoiced and paid on schedule. Informal cost-sharing across affiliates is the Pepper Source fact pattern.

Single-member LLCs get extra scrutiny

In Olmstead v. FTC, 44 So. 3d 76 (Fla. 2010), the Florida Supreme Court held that a judgment creditor of the sole member of a single-member LLC could reach the membership interest directly, because there were no other members to protect under the charging-order statute. Florida later amended its statute to restore charging-order exclusivity for multi-member LLCs while preserving weaker treatment of SMLLCs, and other states watched the reasoning spread.

The practical consequence is that the SMLLC leans harder on entity formality than the multi-member LLC does. If the charging-order wall is lower, the alter-ego wall has to be higher: documented capital contributions, genuine business purpose, an operating agreement even though no one else will read it, records that reflect decisions actually made.

Capital accounts and insurance

Multi-member LLCs taxed as partnerships have one additional discipline: capital-account maintenance under IRC § 704(b). The operating agreement's allocations have "substantial economic effect" only if each member's capital account is properly kept (increased by contributions and allocated income, decreased by distributions and allocated loss, settled on liquidation in accordance with positive balances). Outside of litigation, an incoherent capital account is the first thing a new CPA discovers. Inside of litigation, it is evidence the entity was not run as a partnership.

Radaszewski is the case to remember when someone frames the liability shield as the only thing between a tort plaintiff and the owner's house. The entity's insurance is the first layer: general liability, professional liability where relevant, employment practices where there are employees, cyber where there is data, umbrella above all of it. A piercing analysis that starts with "the defendant carried a $2 million general liability policy and a $5 million umbrella" tends to end before it gets going.

The rule of thumb

Run the entity like it is a stranger you are accountable to, and document the relationship in writing every time money or authority moves.

Sources

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