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Personally Liable? But I'm Incorporated!
So you've incorporated...well, that's just the first step!
by Ross Simmons1
Corporate status generally shields the shareholders of the corporation from individual liability for the acts of the corporation. However, courts will only respect that general rule so long as the corporation remains properly organized, adequately capitalized, and completely separate as a legal entity from its owners.
Limited Liability Is NOT Automatic
Limiting one's liability for damages, particularly in the face of an actual
claim for real damages, is quite clearly a privilege. In the case of corporations,
it is one afforded by law. However, if a court finds that the statutory corporate
privilege has been "abused," the corporate entity may be disregarded for purposes of remedying the specific abuse, and corporate shareholders may be held liable for the corporation's acts relating to that abuse.
The legal theory upon which shareholder liability is based is generally called
the "alter-ego doctrine." An individual attacking corporate status and seeking the personal liability of the shareholder will try to "pierce the corporate veil," to
prove that the corporation is merely an agent of the individuals behind it.
This can be done by proving two things: first, that there is a unity of interest
and ownership between the corporation and the shareholders; and second, that
an injustice or fraud will occur if the corporation's actions are treated
solely as the acts of the corporation.
Guidelines For Avoiding Personal Liability
A corporation can reduce the possibility that the individual shareholders will be subject to liability for the corporation's actions by following these guidelines.
(A) The corporation should ensure that it is adequately capitalized
from the outset, in light of anticipated risks and expenses given the business
in which it is engaged.
(B) The corporation should obtain customary insurance protection.
The corporation should consider all forms of coverage, including general
liability insurance, fire and casualty insurance, life and disability insurance
for key personnel, insurance to fund share repurchases in the event of death
or disability of a shareholder, business interruption insurance, and workers'
compensation insurance.
(C) The corporation should observe all post-formation corporate
formalities. These include holding annual shareholders' meetings
and holding regular directors' meetings; keeping minutes of such
meetings and clear
records of all corporate activities; maintaining up-to-date
Bylaws at the corporate executive offices; maintaining separateness
and arm's length dealings
between the corporation and the arm's length directors and/or
principal shareholders and requiring full disclosure of any competing
interests; and
assuring approval of the corporation's transactions either
by the directors or the shareholders as appropriate.
(D) The officers and other authorized persons must take care
to execute all letters, contracts and other documents, on behalf of the
corporation and in its name, rather than individually. To do this, a signature
should give the name of the corporation and then the officer's signature,
name and title. A signature block is generally drafted as follows:
"Corporate Name Here
By:________________________
John Smith, President"
(E) Corporate funds should not be commingled
with the funds of the individual shareholders or any other entity
involved with the corporation.
Furthermore, the corporation should maintain separate operations
and records from those of other entities or subsidiaries and
its shareholders.
(F) All withholding tax payments should be made.
There Are No "Black And White" Rules
The analysis is very fact sensitive and the courts look carefully at each
case, rather than applying a formula approach. However, the "alter ego" doctrine
has been applied far more frequently to closely held companies, rather than
public companies.
Generally, courts are less likely to "pierce the corporate veil" (meaning,
impose personal liability against the shareholders) to satisfy the claims
of a contract or trade creditor unless there is some actual act of fraud.
This is because creditors can negotiate the risk they will assume in a commercial
transaction and can require security or personal guarantees if they believe
the corporation is undercapitalized. Likewise, if they forego such assurances,
they do so at their own risk. Courts are more likely to "pierce the corporate veil" on behalf of tort victims (for instance, persons physically hurt by corporate employees, persons injured on the premises, etc.), because those creditors did not voluntarily assume the risk of the corporation's limited liability. The courts will "pierce the corporate veil" if
it would be inequitable to limit the shareholder liability.
Specific Circumstances To Be Avoided
But generalities are...well...general. More to the point, "legalese" factors that have historically supported application of the "alter-ego" doctrine,
resulting either in liability against its owners or related entities, are:
(A) Use of a corporation as a mere shell, instrumentality
or conduit for a single venture or the business of an individual or another
corporation;
(B) Failure to adequately capitalize a corporation or the
total absence of corporate assets and undercapitalization;
(C) Commingling of funds and other assets, failure to segregate
funds of separate entities, and the unauthorized diversion of corporate
funds or assets to other than corporate uses;
(D) Disregard of legal corporate formalities and the failure
to maintain arm's-length relationships among the related entities;
(E) Treatment by an individual of the assets of the corporation
as his/her own; formation and use of a corporation to transfer to it an
existing liability of another person or entity;
(F) Use of the same office, business location, assets or
employees;
(G) Use of the corporate entity to procure labor, services
or merchandise for another person or entity;
(H) Failure to issue stock or to maintain minutes or adequate
corporate records;
(I) Identical equitable ownership or control in two entities;
(J) Concealment of the identity of the shareholders;
(K) Use of the corporation for illegal activity;
(L) Use of the corporation to enter into a contract with
the intention of nonperformance and avoidance of personal liability; and
(M) A shareholder holding himself or herself out as personally
liable.
[Associated Vendors, Inc. v. Oakland Meat Co. (1962)
210 Cal.App.2d 825, 838-840.]
No one factor is deemed conclusive. The ability to "pierce the corporate veil" and apply the "alter-ego" doctrine
will depend upon the number and degree of the factors present, and whether
or not the failure to apply the doctrine would result in an injustice to
the claiming creditor.
No Easy Answer...Or Is There?
A very serious topic. At the same time, most steps taken to avoid the "alter-ego" doctrine,
separate and apart from preserving limited liability, are simply good business
practices. For instance, corporate separateness is critical in the context
of maintaining an audit trail should the Internal Revenue Service come calling.
Corporate formalities may seem a nuisance, but at the same time, no court
decision to date has said that corporate meetings cannot be fun (or if the
corporation is owned by spouses, romantic). By discussing these topics with
your attorney and accountant early on, you will likely find that a nominal
effort and expense today can go a long way toward avoiding personal liability
in the future.
And that, after all, was why we incorporated in the first place.
1 This work provides general information only. It is intended to be general
in nature and does not constitute legal advice. You must seek legal advice
for your individual circumstances. Your receipt of this newsletter does not
create an attorney-client relationship. Please see your attorney, or retain
an attorney to address your individual legal circumstances immediately.
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