How You Can Lose Corporate/LLC Protection

One of the main advantages of forming a corporation or Limited Liability Company (“LLC”) is the limited liability protection it affords you from the business’s debts and liabilities. When the business is unable to pay its debts, you want your personal financial risk limited solely to your monetary investment in the business. You need to be proactive on this. That’s why it’s important to create a plan not only for choosing the right entity structure for your business but also that your business practices are set up in the best way possible to maintain protection from such liabilities.

Unfortunately, business owners are far too often unaware of the number of ways they can lose this protection. And sometimes the realization comes too late – a lawsuit has already been filed against them personally to satisfy the business’s debts or liabilities. Now their personal assets are at risk! Don’t be that person. In this article, we will discuss the common law theory that allows business creditors to disregard corporate/LLC limited liability protection.

Corporate/LLC Limited Liability Explained

A corporation is viewed as a separate legal entity, distinct from its stockholders, officers and directors, with separate and distinct liabilities.[1] The same is true of an LLC and its members and managers.[2] Courts have conceptualized the incorporation process as the creation of a (corporate) veil, shielding business owners/managers personally from creditor claims to collect on business debts or liabilities. For example, under this theory, if a patron of a corporate grocery business slips and falls in one its stores, and sues the corporation, the corporation’s shareholders’ personal assets would presumably be protected from the claim.

But Limited Liability Protection Can Be Lost!

But, as is the case with so many general rules, an exception was created. The legal separation associated with corporations or LLCs may be disregarded when they are used by individuals to perpetrate a fraud, circumvent a statute, or accomplish some other wrongful or inequitable purpose.”[3] In those cases, the corporation’s or LLC’s actions will be deemed “to be those of the persons or organizations actually controlling the corporation, in most instances the equitable owners.”[4] “Piercing the corporate veil”, otherwise referred to as the “alter ego” doctrine “prevents individuals or other corporations from misusing the corporate laws by the device of a sham corporate entity formed for the purpose of committing fraud or other misdeeds.”[5]

Two Conditions Required: Unity of Interest + Unfair Result

Before a court decides to pierce the corporate veil, two conditions generally must be met:

1) There must be such a unity of interest and ownership between the corporation and its equitable owner that the separate personalities of the corporation and the shareholder do not in reality exist.” [6]

2) The second condition required before a court will pierce the corporate veil is that “there must be an inequitable result if the acts in question are treated as those of the corporation alone.”[7]

Factors

Courts have developed a list of factors to analyze whether these two required conditions exist to pierce the corporate veil which include the following:

• Commingling of funds and other assets of the two entities

• The holding out by one entity that it is liable for the debts of the other

• Use of the same offices and employees

• Use of one (entity) as a mere shell or conduit for the affairs of the other

• Inadequate capitalization

• Disregard of corporate formalities

• Lack of segregation of corporate records

• Identical directors and officers. [8]

However, “there is no litmus test to determine when the corporate veil will be pierced; rather the result will depend on the circumstances of each particular case.”[9] In other words, the court will undertake a case-specific, fact-intensive analysis to determine whether to pierce the corporate veil.

What To Do?

The bottom line when it comes to keeping the limited liability protection that comes with incorporating is that you need to know the factors courts consider when deciding whether or not to pierce the corporate veil. For instance, understand the impact of disregarding corporate formalities. It is not enough to simply set up your corporation and then to ignore it. Certain ongoing “formalities” must occur. This includes the requirements that a Statement of Information be annually filed with the Secretary of State (Cal.Corp.Code section 1502), an annual meeting of the shareholders must occur at a date and time fixed in the corporate bylaws (section 600), and a “regular” meeting of the board of directors should occur (section 307). These are just a few of many formalities required of corporations.

You should also strongly consider consulting with an experienced business law attorney who can assist with ensuring that you choose the right entity formation for your needs and planning implementation of the right business practices that will increase the likelihood that you will keep your limited liability protection. To that end, please feel free to contact Law Unboxed and we would be happy to assist!

Disclaimer: This article may constitute attorney advertising and is provided for informational purposes only. This article does not constitute legal advice nor does it form an attorney-client relationship. Specifically, this article does not address all potential situations and is in no way intended to apply to your particular situation. Qualified counsel in your jurisdiction should be consulted for your specific concerns and/or needs. If you want more information, please contact Law Unboxed with any questions!

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[1] Sonora Diamond Corp. v. Superior Court (2000) 83 Cal.App.4th 523, 538.

[2] Cal.Corp.Code, sections 17701.04, 17701.05, 17703.04, subd. (b).

[3] Sonora Diamond, supra, 83 Cal.App.4th at 538, Cal.Corp.Code, section 17703.04, subd. (b).

[4] Sonora Diamond, supra, 83 Cal.App.4th at 538.

[5] Id.

[6] Id.

[7] Id.

[8] Id.

[9] Id.