By John B. Alsterda and Christine Polk Mohr, Davis McGrath L.L.C.
A corporation is a legal entity created by or under the authority of the laws of a state. The corporation is distinct from the individuals who comprise it. That is, a corporation is distinct from its shareholders. The term “corporate veil” generally defines the insulation provided to shareholders of a corporation from claims made against the corporate entity for its debts and other obligations arising from contracts entered into by the corporation.
However, in some situations, a director, officer or shareholder of a corporation can be held personally liable for the actions of the corporation. Such cases include certain contractual exceptions, such as when a shareholder voluntarily agrees to guaranty a corporate obligation. In other circumstances, a statute or governmental regulation may take away a shareholder’s liability shield. For example, a shareholder who actively participates in the management of a corporation’s finances may, in some circumstances, be liable for unpaid taxes owed by the corporation.
Another important exception is a judge-made doctrine sometimes referred to as “piercing the corporate veil.” The Unites States Supreme Court has stated that “the doctrine of corporate entity, recognized generally and for most purposes, will not be regarded when to do so would work fraud or injustice.” Courts have specifically identified various circumstances that justify piercing the corporate veil and imposing liability on individuals for obligations incurred by the corporation. Three of the most common are:
- The defendant’s failure to maintain adequate corporate records or to follow corporate formalities
- The commingling of funds or assets between the corporation and its shareholders
- Treating the assets of the corporation as the defendant's own
These scenarios tend to occur when a corporation has only one or two shareholders who also function as its officers and directors, and thereby control all of the corporation’s operations.
Criteria for Piercing the Veil
Some courts have employed a two-part test to determine whether to pierce the corporate veil. First, there must be such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist. And second, adherence to the fiction of a separate corporate existence sanctions a fraud, promotes injustice, or promotes inequitable consequences.
As one might expect, the application of this test, and others like it, is specific to the facts of each case and involves shades of gray. In determining whether the “unity of interest and ownership” criterion is met, most courts will not make a decision based on the presence or absence of a single factor, but will instead examine many factors. Historically, these have included:
- Inadequate capitalization
- Failure to issue stock
- Failure to observe corporate formalities
- Nonpayment of dividends
- Insolvency of the debtor corporation
- Non-functioning of the other officers or directors
- Absence of corporate records
- Commingling of funds
- Diversion of assets from the corporation by or to a stockholder or other person or entity, to the detriment of creditors
- Failure to maintain arm’s-length relationships among related entities
- Whether the corporation is a mere facade for the operation of the dominant stockholders
Protecting the Corporate Veil
To avoid having the corporate veil pierced, shareholders should:
- Adhere to corporate formalities by maintaining good records
- Have the requisite separation between their finances and those of the company
- Prevent administrative dissolution of the corporation by filing all necessary reports and paying all franchise taxes to the state in a timely fashion
- Have an adequate reserve to pay the corporation’s creditors before paying dividends
Using the professional services of accountants and attorneys may help identify and correct potential problem areas before they develop into more serious issues.
Owners of other business entities, such as limited liability companies, limited liability partnerships and professional corporations, may enjoy the protection of a liability shield similar to that enjoyed by the shareholders of a corporation. The extent to which these business owners enjoy such protections, as well as the relevant exceptions, are set forth in the statutes governing each type of entity, and in the judge-made law construing those statutes.
Before forming any type of new business entity, it’s wise to consult with an attorney to get advice about the liability shield that the entity will provide to its owners, and its suitability to the purpose of your enterprise.
Davis McGrath is a law firm with substantial experience in litigation and counseling in the IT services industry, including contract preparation and review. We also focus on intellectual property matters, with a specific emphasis on trademark, domain name, copyright and Internet law matters, as well as corporate law and contract transactions. In addition, we have proven skill and experience in alternative dispute resolution, including arbitration and mediation. Davis McGrath L.L.C. You can find us at www.davismcgrath.com.
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