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Editorial 10 MIN READ

How to maintain separate-entity formality, so the shield actually holds

The small daily hygiene that keeps a creditor's lawyer from arguing your LLC and you are the same person

The Editors
Staff, Incorporator.org
10 min read Updated
Contents 8 sections
  1. What a court actually looks at
  2. The books-and-records rule, in practical terms
  3. Separate bank accounts, and why the card matters too
  4. Arm's-length transactions between related parties
  5. Capital adequacy: the number no statute names
  6. State variation, briefly
  7. The checklist, and the rule of thumb
  8. Sources

he liability shield is not a filing. It is a pattern of behavior that a court looks at when someone sues and asks to be paid by the owner instead of the entity. If the pattern is wrong, the shield comes off.

Separate-entity formality is the phrase lawyers use for the pattern. It means the company has its own books, its own bank account, its own paper, and deals with its owner the way it would deal with a stranger. The cases where the shield fails are almost never about a bad filing. They are about founders who treated the single-member LLC as a second wallet.

What a court actually looks at

Every state has some version of the alter-ego test, and the labels vary, but the factual inputs are close to identical. The most-cited modern statement is the Seventh Circuit's in Sea-Land Services, Inc. v. Pepper Source, 941 F.2d 519 (7th Cir. 1991), which gathered the Illinois factors under a two-part standard: (1) such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist, and (2) circumstances such that adherence to the fiction of separate corporate existence would sanction a fraud or promote injustice. The unity prong is a list, and the list is the one your operating agreement was supposed to prevent you from populating: failure to maintain adequate corporate records, commingling of funds, undercapitalization, and one shareholder treating the corporation's assets as his own.

The Fourth Circuit's DeWitt Truck Brokers, Inc. v. W. Ray Flemming Fruit Co., 540 F.2d 681 (4th Cir. 1976), is the case most cited for piercing when the formalities are absent in the defendant's own records. The court there treated the corporation as the alter ego of Flemming because the directors never met, the books were a fiction, dividends were paid out of money the company did not have, and the shareholder ran the company as a personal business. None of those findings required proof of fraud in the underlying transaction; the disregard of the entity itself supplied the inequity.

The foundational cab-company case is Walkovszky v. Carlton, 18 N.Y.2d 414 (1966), in which the New York Court of Appeals refused to pierce a taxi corporation structured as a network of two-cab entities, each carrying the statutory minimum of liability insurance. The court held that undercapitalization alone does not justify piercing; the plaintiff must plead that the owner was conducting business in his individual capacity through the shells, and that the corporate form was being used to defraud. The case is often cited for the proposition that the veil stays up, but it is just as useful read the other direction: the majority spelled out exactly what would have been enough, and that list is the same list a founder has to beat every day.

Put the three together and the factual record that keeps the shield up is specific. Capital matching the business. Books that exist and tie out. Funds that stay in their own accounts. Transactions with the owner documented as if the owner were a stranger. No one decision turns on any single item; the decisions turn on whether the overall picture is of one person or two.

The books-and-records rule, in practical terms

An LLC needs written records even when the statute seems to suggest it does not. Delaware's LLC Act, at 6 Del. C. § 18-305, gives members the right to inspect company records and presumes those records exist. California's RULLCA, at Corp. Code § 17701.13, requires an LLC to maintain a list of members, the articles, any operating agreement, and financial statements for the last three years. Even in states whose statutes are quieter, the practical standard a court applies in a veil-piercing fight is whether the company kept the kind of records a real business would.

That translates to four artifacts you want on file, with dates, before a creditor's lawyer ever asks to see them.

The first is a signed, written operating agreement, in force before the business took its first dollar, naming the members, their percentages, the manager, and the rules for distributions. Multi-member LLCs do this almost reflexively because the partners argue about it. Single-member LLCs skip it, and then find themselves in a dispute with no document that says who owns what and on what terms. A single-member operating agreement is boilerplate and takes an hour. Sign it, date it, keep it.

The second is minutes, or a written consent in lieu of a meeting, for every decision a prudent company would vote on: admitting a new member, taking on a material loan, buying real estate, paying out a special distribution, adopting a tax election. LLCs are not required by most state statutes to hold annual meetings, but the absence of any contemporaneous decision record is the single most commonly cited formality lapse in the alter-ego case law. A one-page written consent with a date and a signature is enough. The point is not ceremony; it is evidence.

The third is a general ledger or some equivalent bookkeeping that shows every transaction the entity engaged in, tied out to the bank statement, with the owner contributions booked as capital and the owner draws booked as distributions. If your bookkeeping is a shoebox of receipts and a personal credit card, the entity has no books in the sense the case law means, and a court will say so.

The fourth is a federal tax return for every year the entity was required to file one. A single-member LLC default is disregarded and reports on Schedule C or E of the owner's 1040, which is fine for the IRS, but a multi-member LLC owes a 1065 partnership return every year and an LLC electing S-corp treatment owes an 1120-S. Missed returns are a red flag on their face.

Separate bank accounts, and why the card matters too

The single most load-bearing formality is the bank account. If the entity does not have its own checking account, in its own name, under its own EIN, there is no entity to defend. Every federal circuit that has written on veil-piercing treats commingling of funds as near the top of the factor list.

In practice the rule is stricter than it sounds. The entity's bank account pays the entity's bills. The owner's bank account pays the owner's bills. Owner contributions to the business are wires or checks from the owner's account to the entity's, posted to a capital account on the books. Owner draws are wires or checks in the other direction, posted to distributions. The occasional reimbursable expense, paid on a personal card and repaid on schedule, is survivable if it is actually reimbursed on schedule and booked; the pattern of paying personal groceries from the LLC account because the LLC card was in your wallet is the pattern Sea-Land and DeWitt Truck Brokers describe.

A separate business credit card is not strictly required, but it enforces the discipline the bank account alone does not. Two cards in the same wallet, both ending in your name, with purchases mingled on both, will read to a judge the way it reads on paper: as one pile of money.

When an owner lends money to the LLC, the LLC lends money to a sister company, or a parent holding company takes a dividend up from a subsidiary, the transaction has to look the way it would look if the parties were strangers. That means, in descending order of importance: a written instrument for the obligation (a promissory note for a loan, a services agreement for an ongoing charge, a lease for the use of property), an interest rate at or near the Applicable Federal Rate published monthly by the IRS, a repayment schedule that is actually followed, and accounting entries on both sides that match.

Intercompany loans are the most commonly defective category. The parent fronts operating cash to the subsidiary, no note is signed, no interest is charged, no repayment ever occurs, and two years later a creditor of the sub sues the parent and argues the transfer was really a capital contribution that should be trapped in the sub, or alternatively that the sub and parent are the same entity. The note does not have to be long. The AFR is public; the May 2018 short-term rate is in the mid-twos and the long-term is in the low threes. A one-page note at AFR, booked on both sides, is the fix.

Intercompany leases, licenses, and management fees are governed by the same instinct. If the parent is charging the sub for shared office space or shared executives, there should be a signed agreement and a rate a third party would pay. The IRS polices the outer limit of this under the transfer-pricing rules of IRC § 482 for related parties, but the veil-piercing risk lives below the IRS's threshold: a state court does not need § 482 to say a charge that appears on neither side's books is not a real charge.

Capital adequacy: the number no statute names

No state statute sets a minimum capitalization for an LLC. The Walkovszky majority held that thin capitalization alone does not pierce, but every circuit that has considered the question lists undercapitalization as a factor, and in a close case it tips the other factors over. The test is not a dollar number; it is whether the company was capitalized at a level reasonable for the risks it was taking. A cab company carrying minimum insurance on a fleet that could kill pedestrians is the Walkovszky fact pattern and survived on pleading grounds; a construction LLC with no insurance, one job in progress, and $500 in the account after distributions will not.

The practical rule is that the entity should carry enough cash, insurance, and contract protection to cover the foreseeable liabilities of its actual business, and that the owners should not be pulling distributions that leave the entity unable to meet current obligations. The accounting term for that is solvency; the lay term is that you do not strip the company. When states have amended their LLC acts to tighten distribution rules, they have done so with solvency language: Delaware's 6 Del. C. § 18-607 prohibits distributions that would leave the LLC unable to pay its debts as they come due. Most other states have an analogous provision. Following it is both the statutory floor and the evidentiary record.

State variation, briefly

The standard looks different depending on whose law applies. Delaware is strict with alter-ego claims against LLCs; the Chancery Court tends to insist on proof of fraud or injustice on top of the unity factors, and it is comfortable dismissing piercing claims at the pleading stage when the plaintiff has only recited formality lapses without showing harm. California, under the alter-ego doctrine articulated in cases like Mesler v. Bragg Management Co., 39 Cal. 3d 290 (1985), applies the two-pronged unity-plus-inequity test more flexibly and is more willing to let a piercing claim survive to trial on a mixed record. New York, following Walkovszky and its progeny, requires a showing that the owner used the entity to commit a wrong against the plaintiff, not merely to conduct business thinly. Illinois, after Sea-Land, uses the federal-style factor list and is one of the more plaintiff-friendly jurisdictions.

Which law applies is itself a fight. The internal affairs doctrine points most courts to the law of the state of formation for questions about the relationship between the entity and its owners, but veil piercing sits at the border with tort and contract law and is often decided under forum law, especially when the plaintiff is a local creditor of a foreign-qualified LLC. A Delaware LLC operating in California can find itself judged by California's alter-ego standard on a claim brought by a California vendor.

The checklist, and the rule of thumb

Separate-entity formality is not a one-time project; it is a habit. The short version:

  • A written operating agreement, signed, on file before operations start.
  • Written consents or minutes for material decisions, with dates.
  • A general ledger tied to bank statements, with capital and distributions posted correctly.
  • A separate checking account in the entity's name under its own EIN, used only for the entity's business.
  • A separate business card, or strict reimbursement discipline if you share.
  • Intercompany loans documented by a note at AFR, with real payments.
  • Intercompany services, leases, and licenses memorialized in writing at rates a third party would pay.
  • Distributions that leave the entity solvent under the state's LLC act.
  • All required federal and state returns filed on time.

A plaintiff's lawyer trying to pierce the veil is reading your records for the story they tell. If the records say a company existed, paid its bills from its own account, kept its paper, and transacted with its owner at arm's length, the story is unhelpful to the plaintiff and the case usually ends on the pleadings. If the records say the owner ran the bank account as a joint wallet and signed nothing, the story tells itself.

The rule of thumb: if you would be comfortable handing the full file to a bankruptcy trustee tomorrow morning, the shield is doing its job; if any part of that sentence made you wince, fix that part this week.

Sources

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