A scenario that entrepreneurs are unlikely to encounter, but should nevertheless be cognizant of, is the doctrine of piercing the corporate veil. I’ve discussed the concept before, but as a refresher, piercing the corporate veil occurs when a corporation’s creditors ask a court to proceed directly against a corporation’s owners and their personal assets, bypassing, or “piercing” the limited liability shield of the corporation. In order to do this, the creditors must allege and prove that the corporation is not a distinct entity, but a mere “alter ego” of its owners — specifically, the owners must be disregarding corporate formalities, misusing or co-mingling corporate and personal funds, or undercapitalizing the business, among other factors.
Interestingly, though, is what happens when the creditors of a *LLC* want to pierce the limited liability shield of the LLC. Some states have not yet resolved the issue, either by statutes or by case law. Delaware, which generally tends to lead trends in business law, appears to hold that the piercing the corporate veil doctrine should be applied just the same to LLCs as it is to corporations. However, some legal scholars have argued that LLCs are fundamentally different from corporations in such a way (including lack of corporate formalities, no express requirement to capitalize, etc.) that the piercing of the corporate veil doctrine cannot apply to LLCs, and that another standard, such as a fraud standard, should be applied instead.
If you’re running a LLC in a state that has not yet definitively answered this question, you may be asking yourself how you can ensure that, in the event your LLC defaults on its obligations, the creditors don’t come after you. Until your state has definitively resolved the matter, the best course of action is to assume the piercing of the corporate veil applies — it is generally more strict that some of the other fraud-based standards proposed by legal scholars, not to mention that if the issue were to come before a state court, there is a good likelihood that they might follow Delaware’s lead on the issue. So follow whatever administrative formalities might be in your operating agreement, ensure that you’re not co-mingling your personal finances with the business’, definitely don’t use business funds for personal matters, and make sure that when you start you’ve put in a reasonable amount of capital to cover the business’ liabilities for the next couple months.