Whether you are new to owning a company or are a seasoned entrepreneur, entering into contracts is a fundamental part of being in business. These agreements will vary in size and scope and can result in some obligation or debt being incurred by the company.
Now, in most cases, if you choose the appropriate structure for your organization (such as a corporation or LLC) you, as the owner, are shielded from liability in the event that the company cannot carry out its responsibilities. In other words, you would not ordinarily be on the hook for the resulting debts and legal obligations.
However, it’s important to note that there are times when this protection can be stripped away. This is referred to as “piercing the corporate veil” and means that owners will be held personally financially liable for the debts of the business.
When Will California Courts Pierce the Corporate Veil?
As you might imagine, due to the implications of this type of remedy, courts are reluctant to pierce the corporate veil. In most cases, it is limited to situations in which there is evidence of serious misconduct by the owners.
In fact, two conditions must be present for courts to remove personal liability protection. First, there must be what is known as ”unity of interest and ownership” between owners and the company. This would apply in situations where the owners failed to properly separate themselves from the business. In other words, the company is merely an “alter ego” of the owners.
Second, it must be found to be unjust to allow the owners to shield themselves from liability. Note that if the business is a fraudulent company, this condition is automatically satisfied. A fraudulent company is one that was created solely for the purpose of escaping liability. Keep in mind that a business needs to have a legitimate purpose for its creation, and cannot be used to hide assets.
Factors the Court Will Consider
With that in mind, courts look at a number of factors in order to determine whether there was a “unity of interest” with the business or “alter ego”. Specifically, any of the following conditions can tip the balance in favor of piercing the corporate veil:
Commingled funds: refers to assets between owners and the company being combined. An example would be an owner not having a separate bank account for business.
Personal guarantee on a debt: here an owner holds himself out as being responsible for the company’s financial obligations, such as co-signing on a loan.
Inadequate capitalization: in this case the company does not have enough money or assets in its account to do the work it claims to be doing. Note that this will be highly dependent on the kind of business the company is engaged in.
Disregarding corporate formalities: examples include failure to hold meetings, record minutes, or complete annual filings. It is critically important to follow the rules contained in your operating agreement for the LLC. Bear in mind that these provisions are unique to the organization and not all businesses will be required to have meetings.
“Bad faith” actions by the owners: this would occur in cases where owners purposefully misused the corporate structure. An example would be if you intentionally had the business take out a loan knowing that it would be unable to pay it.
What Happens if the Veil is Pierced?
It’s important to note that piercing the corporate veil does not result in the business being dissolved. Further, in some cases, the veil may be pierced for only some owners or shareholders and not others.
For example, if only one owner was responsible for commingling assets, he or she could lose liability protection while the other owners would not. As you can see, these types of cases can get complicated, so it’s always best to reach out to an attorney if you or another owner are concerned about personal liability.