Shielding personal assets from corporate liabilities is generally one of the primary purposes of incorporation. However, many business owners who have incorporated their business do not realize that the law allows creditors, and other claimants, to "pierce the corporate veil" of improperly maintained corporations and go after the owner's personal assets (home, bank account, investments, and other assets) to satisfy corporate debt, obligations and liabilities. 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. To preserve your liability protection, your corporation must be considered an entity unto itself, separate and distinct from its shareholders (owners)—you!
Piercing The Corporate Veil In California.
In California, to "pierce the corporate veil," a court must find: (1) "unity of interest and ownership" between the corporation and the shareholders such that the identity of the corporation and the individual shareholders are no longer separate; and (2) that to preserve the corporate identity and allow its owners to dodge personal liability would cause an "inequitable result". The key to protecting the limited liability protection afforded by the corporation is for you the owner of the corporation to treat your business as a separate and distinct entity by carefully maintaining the corporation's separateness through issuance of stock, adequate capitalization, observation of corporate formalities, proper maintenance of the corporate minute book, and proper maintenance of financial records. These actions will help prevent a potential plaintiff or litigant from proving "unity of interest and ownership" between the corporation and its shareholders (owners).
Finding Unity Of Interest.
To prove "unity of interest and ownership" and in turn expose the owners (shareholders) of a corporation to personal liability generally requires the court to find that the owners failed to respect corporate separateness by one of the following:
- Failing To Issue Stock.
Failure to issue stock is a failure to perform one of the basic requirements of a corporation.
- Failing To Initially And Adequately Capitalize The Corporation.
If the corporation has never been funded, there is no financial basis for the corporation to be a separate entity. In addition, the corporation must be funded with sufficient funds relative to the size and nature of the business to ensure the corporation is financially viable. The amount of initial money or property that constitutes adequate capitalization is anybody's guess but courts generally: (1) compare the amount of money contributed to the nature and magnitude of the corporate undertaking and (2) look at the owners intent. In other words, was the company set up with the idea of defrauding its creditors? How long after the owner contributed capital to the company did the owner contract liability on behalf of the Company? Was the liability reasonable or grossly disproportionate to the amount of capital contributed?
- Commingling Corporate and Personal Assets or Funds.
Failing to keep corporate and personal assets separate and distinct, exposes the corporation to the charge that there is "unity of interest" such that the corporate bank account is really just a personal asset of the individual shareholder(s). Its essential to keep your personal assets and funds separate and apart for those belonging to the corporation. Do not pay personal bills and expenses with a corporate check or credit card. Do not pay business related expenses with a personal check or credit card. Do not use the same office or business location for the corporate business and some other business.
- Failing To Keep Separate Corporate Financial Records.
If the separate status of the corporation cannot be established through normal accounting records and financial statements, shareholders will be held personally liable. It is very important to maintain shareholder and director approvals of significant corporate activities including borrowing, compensation and purchase decisions.
- Domination and Control of the Corporation By One Shareholder or a Few Key Individuals.
This issue alone will not lead to a piercing of the corporate veil, but often will if coupled with one or more of the other factors like failing to maintain corporate records and minutes. 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. 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. A sole shareholder must therefore be extremely more cautious about respecting the separate identity of the corporation. The following points should be of particular concern to a sole shareholder.
- Failing To Hold Meetings Of The Shareholders/Directors.
Holding regular meetings of the shareholders and directors is a primary means of preserving the separate identity of the corporation. Failing to perform these acts, creates a basis for "unity of interest." State statutes require corporations to hold, at the very least, annual meetings to elect directors and to approve of fundamental changes such as a consolidation or merger. During these meetings, minutes should be kept in writing, votes counted, directors elected, etc…
- Failing to maintain corporate records and minutes.
While it may sound extreme, I regularly see corporate minute books devoid of minutes.
Fraud – Forming The Corporation to Avoid An Obligation or to Perpetrate a Fraud.
Another way to pierce the corporation veil is to prove "fraud." The courts will disregard the corporate entity when it is necessary to prevent fraud or to prevent an individual shareholder from using the corporate entity to avoid his existing personal obligations. In other words, a shareholder can't set up a corporation without a valid business purpose. Shareholders should not siphon funds in an effort to "judgment proof" the corporation. Shareholders should be careful to not mislead third parties into thinking that shareholders will perform the corporation's obligations or that the corporation has assets that are really personally owned by the shareholders. If the corporation becomes insolvent or in financial distress, don’t incur additional debts or liabilities.
Don't Lose Your Limited Liability Protection.
Each of the above-mentioned factors may be used to pierce the corporate veil and hold the owners of a corporation personally liable for what may be legitimate corporate debts and responsibilities. Take your ownership responsibilities seriously and treat your corporation as a separate and distinct entity. Use a bookkeeper or accountant to keep track of your corporation's income and expenses. Comply with all of the governmental reporting requirements. Hold your annual meetings, hold special meetings to approve unusually large or uncommon transactions, and maintain your corporate minute book. Most importantly, seek legal counsel if you are confused or unsure about whether you are in compliance with any of the elements discussed above!