The Business Advisor PERSONAL LIABILITY: Piercing the Corporate Veil. by Mary Hanson

Business owners who have incorporated their businesses must be aware that corporate shareholders may be held legally responsible for the liabilities of the corporation. The law allows creditors or claimants to "pierce the corporate veil" under certain circumstances and hold the shareholders personally liable.

The theory behind this legal concept is that shareholders who blur the distinction between the corporation and themselves should not be allowed to hide behind the corporate veil.

Piercing the corporate veil should not be confused, however, with direct personal liability. If a business owner takes some action (or fails to take some action that he is legally obligated to take), the responsibility for resulting damage or injury is the individual's, whether or not the business is incorporated.

For example, if a business owner driving a car causes injury to another person in a car accident, the business owner will be liable for that injury, whether or not the accident occurred on company business, whether or not the company is incorporated, and whether or not the corporate veil is strong.

In contrast to a claim of direct personal liability, a claim attempting to pierce the corporate veil is part of a lawsuit against a corporation. The plaintiff in such an action seeks to extend the liability of the corporation to the shareholders, on the basis that they are shareholders and that the law on "piercing the corporate veil" applies to the circumstances involved in the lawsuit.

California Law

California cases dating back to the early 1900's have consistently held that two requirements must be met before shareholders can be exposed to liability under California law.

First, there must be such a "unity of interest and ownership" between the corporation and the shareholders that the personalities or identities of the corporation and the individual are no longer separate.

Second, it must be found that, if the acts are treated as those of the corporation alone, there will be an "inequitable result."

In California court cases on piercing the corporate veil, the circumstances that most often expose shareholders to personal liability through a piercing of the corporate veil include the following:

* Failure to issue stock. This corporate defect shows up in many of the cases in which shareholders were held liable for corporate obligations. Failure to issue stock is failure to perform one of the basic requirements of a corporation.

* Failure to capitalize the corporation. If the corporation has never been funded, there may be no financial basis for the corporation as a separate entity.

*"Inadequate capitalization." The corporation must not only be funded, but must be funded with an amount of money that is adequate to make the corporation financially viable.

There is no case, statute, or regulation which defines the amount of capital that is required to avoid personal liability. The cases where the courts found the capitalization inadequate are so extreme that they are not helpful in clarifying an adequate level of capital. Consequently, it is best to be conservative and invest more money in exchange for stock rather than less. The amount must be based on the financial needs of the business.

* Domination of the corporation by one shareholder. Many small businesses are dominated by one shareholder, and it is especially important for such businesses to keep up all other formal aspects of maintaining a separate corporation. This issue alone will not lead to a piercing of the corporation, but domination of the corporation, along with other factors included in this list, can create a total picture justifying a piercing of the corporate veil.

The term and the concept of "domination of the corporation" was developed years ago under prior California law, under which three directors were required, with each owning stock in the corporation. Apparently, it was thought that domination of the corporation by one person was improper. California corporation law now allows a single shareholder to own and operate a California corporation, obviously dominating it. The old cases that consider domination of the corporation important can still be considered in a case decided today. A lawyer defending the piercing of the corporate veil must make the court aware of the changes in corporation law.

The concept of a shareholder dominating a corporation is common under laws of many states. Most frequently it is called the "alter ego" ("other self") doctrine and it means that the shareholder uses the corporate assets as his or her own. Under California law, a claim that one shareholder dominates the corporation or that the corporation is the "alter ego" of the shareholder is just another way of saying that there is a "unity of interest" between the corporation and the shareholder.

Because of this background, a sole shareholder must be more cautious about respecting the separate identity of the corporation. The issues listed here should be of particular concern to a sole shareholder.

* Failure to maintain corporate records. Many of the reported cases involve the failure of the corporation to have even one meeting. This seems like an extreme situation, but I regularly see corporate minute books devoid of minutes. Missing a few meetings or neglecting to prepare minutes of meetings may not mean much by itself, but lack of minutes could put you at a disadvantage in the event a business claimant tries to sue you as a shareholder.

* Failure to keep corporate financial records. If the separate status of the corporation cannot be established through normal accounting records and financial statements, shareholders are in big trouble. The reported cases do not discuss the status of financial records, but this issue goes to the heart of maintaining a separate entity. I cannot imagine a corporation failing to maintain separate financial records and surviving a challenge to the corporate status.

* Failure to distinguish between corporate and personal assets. The corporation should have and maintain its own assets. Many of the reported cases involve the commingling of personal and corporate funds. The charge that is made is that the corporate bank account is treated as an asset of the individual shareholder. Similarly, the personal use of other corporate assets can give rise to an argument that the identities of the corporation and shareholder are blurred.

* Creation of a corporation for purposes of avoiding an obligation or perpetrating some type of fraud. In a 1950 case involving a divorce, the plaintiff wife was allowed to pierce the corporate veil of the husband's corporation because the court found that the corporation was formed to enable the husband to reduce his income and thereby to reduce the amount of payments to the ex-wife.

Overall, if your corporation is sued, you should anticipate that the plaintiff may seek to have you named personally in the lawsuit, claiming that you are liable as a shareholder because you have failed to maintain the separate identity of the corporation.

How to Protect Yourself

In California, the closely held corporation's key to protection is in carefully maintaining the corporate separateness through adequate capitalization, observation of corporate formalities, issuance of stock, and maintenance of separate financial records.

Steps to take to avoid a piercing of the corporate veil include the following:

* Adequately capitalize the corporation. Do not allow the corporation to be financially dependent on shareholders for working capital.

* Make sure stock is issued and that you have complied with requirements relating to issuance of a security.

* Maintain corporate records, including minutes of shareholders’ and directors’ meetings held at least annually.

* Maintain separate financial records. Keep balance sheets and profit and loss statements from each year.

* Maintain separate bank accounts for the corporation, and make few loans between the shareholders and the corporation. Document all loans made and make payments in accordance with the repayment terms.

* Do not verbally assure corporate creditors that you will personally take care of corporate obligations if the corporation is unable to. Do not blend corporate and personal obligations.

Lastly, make sure, if you are sued, that an adequate defense is presented in response to the attempt to pierce the corporate veil. It is up to the attorney defending the claim to brief the court on the requirements under the applicable state law on the issue.

(c) Copyright 1997 Mary Hanson. All rights reserved.