Not so fast.
Under some circumstances a corporate entity may be disregarded and the shareholders can be held personally liable for debts. Disregarding the entity is known as, “piercing the corporate veil.” This “piercing” can occur when:
(1) the corporate goals and formalities are ignored;
(2) the corporation is undercapitalized; and
(3) used to prevent fraud.
What does all of that mean? Hopefully the following will help a shareholder take advantage of a corporation in order to protect his/her personal assets. Over the years a number of tests have been developed to address this issue. Here are the most common:
- Alter Ego (Ignoring Corporate Goals and Formalities). If the shareholders treat the assets of the corporation as their own, use corporate money to pay their personal bills, fail to hold shareholders’ or directors’ meetings, fail to issue stock or generally disregard corporate formalities, the courts will often find that the corporate entity is a mere “alter ego” of the shareholders. Suggestion: Maintain separate bank accounts for the corporation and its shareholder(s); shareholders should never have the corporation pay a personal debt; have the corporation issue stock certificates – it’s easy; and hold and document annual meetings of shareholders and directors.
- A corporate shareholder, i.e., a parent company, will be held liable on pretty much the same basis as the shareholders stated above. It is important to know if in a parent-subsidiary situation, whether each corporation was held out to the public as a separate entity. If they were not, the chances increase that someone may be able to “pierce the corporate veil.” Suggestion: In addition to the above, make sure each corporation has separate phone numbers, fax numbers, e-mail addresses, business cards, and if possible different physical locations.
- Where the same shareholder(s) owns stock in several corporations, a question may arise as to whether one of the corporations, although not strictly related to another, should be held liable for the other’s debts. If several corporations are conducting what in essence is a single business, the risk that the separate existence of each corporation will be ignored is greatly increased, particularly if transactions between the corporations result in the assets tending to cluster in one corporation while the liabilities tend to accumulate in another. Suggestion: Keep separate books and records for each entity. Do not send one corporation’s correspondence to a third party and do not copy the other corporation on that correspondence. Also, consult with a CPA as regarding how the assets and liabilities should be stated.
- Undercapitalization. Suggestion: Have your CPA or forensic accountant carefully review the corporation’s financial state and provide you an opinion.
- There is a very strong possibility that shareholders will be liable if they fail to provide adequate capitalization for the corporation. Compliance with a state’s minimum requirement (e.g., the Texas requirement of at least $1,000.00 capitalization) does not assure a finding of adequate capitalization. The general rule is that the shareholders must “put at risk of the business unencumbered capital reasonably adequate for its prospective liabilities.”
- Avoid Existing Obligations or Fraud. Suggestion: This is a no-brainer. Do the right thing.
- The corporate entity will be disregarded any time it is necessary to prevent fraud or to prevent an individual shareholder from using the corporate entity to avoid his existing personal obligations.
- When the corporate veil is pierced, normally only the shareholders who were active in the management or operation of the business will be held personally liable. In other words, passive investors who acted in good faith will not be held liable for the corporate debts. Suggestion: Any shareholder who disagrees with the proposed corporate act should state so in writing, and send it to all of the other shareholders, directors, officers and the corporate secretary asking her to file in the corporate minute book. Oh, and keep a copy.
- When shareholders are liable, they normally will be held liable for the entire amount of the claim, even it if exceeds the amount that would have been considered “adequate capitalization.” Liability is joint and several.
- Who may “pierce the corporate veil?” The court will be sympathetic to creditors whose claims arise from tortious acts committed by the corporation. In a contract dispute it is harder to accomplish the piercing. Suggestion: Note your disagreement as stated above.
Treat your “corporate veil” like a very special garment. It must be protected and maintained, just like any fine apparel. Don’t store it with your day-to-day, casual clothing. It deserves to be kept clean and safe, ready to shroud your head and back during formal legal matters.
Mark A. Alexander
5080 Spectrum Suite 850
Addison, Texas 75001