An asset protection plan is crucial to running a successful business. If your business entity is not formed and governed properly, a judgment creditor can “pierce the corporate veil” and get to your personal assets.
Piercing the Corporate Veil: Alter Ego Liability
Alter ego liability is how the corporate veil is “pierced”. There is a two-prong test for establishing alter ego liability. First there must be shown a unity of interest between the corporation and its shareholders such that there is no separate existence. There must be a finding that upholding the corporation, and allowing the shareholders to escape personal liability, would promote an injustice. A corporation is presumed by law to be separate and not the alter ego of its shareholders. Bad faith must be proven to overcome this presumption. Even if the corporation is pierced, only shareholders who actively participated in the abusive conduct can be held personally liable. As such, your passive investors generally aren’t personally liable for corporate liabilities.
There are numerous factors considered in piercing the corporate veil. Not just one of the following factors will be sufficient to pierce the corporate veil and some combination of the following must be proven to such an extent that the court determines that it would be unjust to allow the shareholders to hide behind the corporate shield.
- Failure to Properly Originate the Corporation. There are numerous processes and steps that must be undertaken to properly form a corporation. The vast majority of corporations formed by the business owners themselves or through the use of a form service, such as Legal Zoom, are deficient in one or more of the formalities. For example, frequently the documents returned to the business owner from the form service are not properly executed, no stock certificates are issued and the organization never had a first organizational meeting.
- The Corporation is Inadequately Capitalized. Although there’s no bright line test and capitalization is determined by a case-by-case basis, the general rule is that the corporation must be formed with enough cash to pay for all assets and to cover all business expenses to its break-even point.
- Failure to Run the Corporation as a Separate Legal Person. Failing to treat the corporation as a separate legal person means that the owners of the corporation treat the corporation’s assets as their own and don’t hold the corporation out as a separate entity. For example, the owners may sign contracts and correspondence in their own name personally (not in their corporate capacity), the owners may pay personal expenses from the corporate bank accounts, make undocumented loans to or from the corporation, comingle funds, fail to hold shareholder or director’s meetings and/or fail to maintain the corporate formalities.
- Acting in Bad Faith. Bad faith must be proven in order to pierce the corporate veil. Bad faith can come in many forms, including misrepresentation, self-dealing and gross negligence.
The bottom line is that every business needs a business entity. Every business entity needs to have its organizational process completed and to be treated as a separate legal entity. And finally, every business owner needs to follow the “golden rule” by treating others the way they desire to be treated, in order to avoid an allegation of bad faith.