One of the Biggest mistakes Business Owners Make (and why you should be careful when taking advice from online ‘Business Gurus’)
One of the big advantages of forming a corporation is the protection from personal liability provided to it’s shareholders. In fact, the purpose for most individuals forming a corporation is to shield its shareholders from these corporate liabilities. The mere forming a corporation establishes a presumption of the corporation’s separate existence, but this presumption can be overcome by a creditor.
In other words, the key benefit for forming a company is protecting the personal assets that you as the entrepreneur own, from legal issues that your company faces.
But unfortunately, this protection is not automatic. And there are self styled social media experts whose #fakenews are not just misleading but dangerous. What do I mean? It means that business owners are often led to believe that using their company to fund their lifestyle is admissible. After all "everything is tax deductible".
I'm talking about the alter ego test.
Alter Ego Doctrine
The alter ego doctrine is a method of invoking personal liability on a corporation’s shareholders or a limited liability company’s members. The doctrine can apply when the court finds a lack of distinction between the shareholders and the corporation
Federal Alter Ego Liability Three-Part Test
A federal court will consider three factors when determining whether the alter ego doctrine will apply and the corporate veil may be pierced:
- The amount of respect given to the separate identity of the corporation by its shareholders;
- The degree of injustice visited on the litigants by recognition of the corporate entity; and
- The fraudulent intent of the incorporators.
California Alter Ego Liability Two-Part Test
Each state of course has its own laws. A California state court will consider two factors when deciding whether the alter ego doctrine will apply and the corporate veil may be pierced.
- There is such a unity of interest between the corporation and its shareholders that they have no separate personalities; in essence, the shareholders have treated the corporation as their alter ego; and
- It would promote an injustice to uphold the corporate entity and permit the shareholders to escape personal liability for its obligations.
Examples Leading Towards Alter Ego Doctrine
These examples are certainly not an exhaustive list; however, they provide some insight into circumstances that may lead a court to pierce the corporation veil under the alter ego doctrine. There are dozens of already decided legal cases that have created a long list of fact specific scenarios when the alter ego doctrine was used to pierce the corporate veil. Our Sacramento business attorneys understand the necessary steps to ensure proper compliance.
- Commingling personal and corporate funds and other assets;
- Issuing stock with out authority;
- Shell corporations;
- Misrepresentations of ownership, assets, and financial interests;
- Avoiding creditors by transferring assets to shareholders; and
- Failure to issue orders in the name of the corporation.
A 2014 Example: Wells Fargo Ban, N.A. v. Weinberg
In Wells Fargo Ban, N.A. v. Weinberg, an attorney thought he could personally avoid a creditor, but was caught under the alter ego theory. Steven J. Weinberg had a corporation called, Steven J. Weinberg, a Professional Law Corporation. The corporation established a business line of credit with Wells Fargo and owed roughly $57,000 after default. Wells Fargo sue both the corporation and Mr. Weinberg. Mr. Weinberg was personally protected from liability until Wells Fargo pursue the alter ego doctrine.
Wells Fargo argued that Mr. Weinberg drained the corporation’s assets before dissolving it. Mr. Weinberg then began operating under the name of “Steven J. Weinberg a Trial Lawyer” and continued the same practice at the same location as the previous corporation. Mr. Weinberg had also drafted 200 checks identified as “loan repayments” from the corporation to himself and his wife. The amount of the checks disbursed was $420,982. The court found for Wells Fargo under the alter ego theory stating, “[b]ecause it looks to me that you did a fairly obvious thing. You starved the corporation of revenue, continued your practice, and left, arguably, yourself, and your wife, and Wells Fargo holding the bag.” The court also found that “when the corporation needed money, you wrote a check to the corporation and when you needed money, the corporation wrote you back a check.”
It was apparent the corporate was a shell. Mr. Weinberg did not produce any corporate minutes, resolutions, or authorizations. Simply put, the corporate formalities were lacking.
Piercing the Corporate Veil
"Piercing the corporate veil" refers to a situation in which courts put aside limited liability and hold a corporation's shareholders or directors personally liable for the corporation’s actions or debts. Veil piercing is most common in close corporations.
While the law varies by state, generally courts have a strong presumption against piercing the corporate veil, and will only do so if there has been serious misconduct. Courts understand the benefits of limited liability, as it "encourages development of public markets for stocks and thus helps make possible the liquidity and diversification benefits that investors receive from those markets."
As such, courts typically require corporations to engage in fairly egregious actions in order to justify piercing the corporate veil. In general this misconduct may include abusing the corporation (e.g. intermingling of personal and corporate assets) or having undercapatitalization at the time of incorporation.
In general, creditors have no recourse against corporate shareholders, as long as formalities are satisfied. When, however, the corporation is fraudulently created to escape liability, then creditors may pierce the corporate veil.
How States' Laws Differ
Laws regarding the piercing of the corporate veil vary from state to state, as demonstrated below.
- That the relevant corporation is only the alter ego or mere instrumentality of the parent corporation or its shareholder(s)
- That the alleged parent company or shareholder(s) also engaged in improper conduct
- Disjunctive test
- either excessive control or corporate misconduct must be shown for the court to pierce the veil
- Conjunctive test
- both excessive control and corporate misconduct must be shown for the court to pierce the veil
Nevada uses a three-part test to determine whether a court may pierce the corporate veil:
- The corporation must be influenced and governed by the person asserted to be its alter ego
- there must be such unity of interest and ownership that one is inseparable from the other
- the facts must be such that adherence to the fiction of separate entity would, under the circumstances, sanction a fraud or promote injustice
In New York, Walkovsky v. Carlton is a leading case on piercing the corporate veil. The court in that case held that a plaintiff needs to prove that a shareholder used the corporation as his agent to conduct business in an individual capacity. A court will pierce the corporate veil when it finds that the corporation is an agent of its shareholder, and will hold the principal vicariously liable, due to the respondeat superior doctrine.
In Texas, In re JNS Aviation, LLC (2007) is a leading case. The court found that the corporate veil could be pierced when any of the asserted veil-piercing strands are met. Further, courts will pierce the corporate veil when the member(s) intended to use the company to perpetrate an actual fraud, and the company did perpetrate an actual fraud "primarily for the direct personal benefit of the considered defendant."
To fulfill the strand component, the corporation must be 1 of 3 things:
- The alter ego of the parent corporation or its shareholder(s)
- The corporation is used to avoid legal limitations upon natural persons or corporations
- The corporation is a sham to perpetrate a fraud.
Further, the court stated that "actual fraud" occurs when all 4 of the following take place:
- "a party conceals or fails to disclose a material fact within the knowledge of that party"
- "the party knows that the other party is ignorant of the fact and does not have an equal opportunity to discover the truth"
- "the party intends the other party to take some action by concealing or failing to disclose the fact"
- "the other party suffers injury as a result of acting without knowledge of the undisclosed fact"