Piercing the corporate veil is the judicial act of imposing personal liability on the shareholders and/or directors of a corporation by "lifting the corporate veil", in contravention to the usual policy that a corporation is a separate legal entity and provides limited liability protection to its shareholders and directors from business debts and liabilities. In such a situation, the court lifts the corporate veil or cloak to allow liability to attach to the individual corporate constituents.
When a creditor or predator discovers or suspects that a corporation does not have sufficient assets to satisfy its claim, and discovers or suspects that one or more of the entity's shareholders do have such assets (for example, real estate with equity or a brokerage account), the creditor or predator will often seek to "pierce the corporate veil" to impose personal liability on the shareholders and/or directors. The alter ego doctrine permits a court to do this where the corporation is, in essence, a sham or a fraud, incorporated or operated primarily to defraud others, and/or treated as the alter ego of, one and the same as, its owner(s).
While courts in California and elsewhere view this an extraordinary measure, and the request is not routinely granted, in deciding whether the corporation's limited liability should be disregarded, the courts consider factors such as fraud/misrepresentation, undercapitalization (or "thin capitalization"), intermingling corporate and personal funds, failure to maintain minutes and to observe other corporate formalities, such as signing checks and contracts in the corporation's, rather than the shareholder's, name. Courts lift the veil, voiding the entity's limited liability protection, to avoid an unjust outcome, to prevent fraud, and to further public policy goals.
Reviewing a sample complaint requesting piercing of a corporate veil may be instructive in noting what courts - and plaintiffs' attorneys - look for (although this is a public record, parties' and attorneys' names and other identifying information have been redacted). Tax authorities such as the IRS have also used piercing-the-corporate-veil arguments against taxpaying entities in order to void tax advantages and capture more tax revenue.
It is not difficult to plead an alter ego situation in California state courts, so a corporate shareholder or director may well be named in a legal action if their corporation is named. Once the allegation has been made in a legal proceeding, it is important to defend against it and attempt to have these individual parties dismissed from the matter as quickly as possible.
The alter ego doctrine can also be applied to limited liability companies (LLCs) and their members and managers; however, because LLCs are typically structured to avoid the need for formalities such as annual meetings, it is in a sense more difficult for the alter ego doctrine to apply to a properly organized LLC. LLCs also offer better limited liability protection than corporations in certain other respects, but, like all business entities, this fact does not dictate the use of one entity type in all circumstances. LLCs offer charging order protection from "reverse piercing", also known as "outside liability", which is an effort on the part of a personal creditor of an LLC member to reach the LLC's assets to satisfy the member's debt to the judgment creditor, while corporations do not offer this protection to their shareholders. Consequently, a creditor of an owner can directly reach the owner's shares in a corporation, but not the owner's LLC membership interests.
A properly set up and maintained corporation, likewise, will not be a good target for veil piercing. The problem is that the average corporation is not properly organized (for example, this office has yet to see a do-it-yourself or online corporation or LLC that meets this standard) or maintained, and thus has at least typically some of the factors present. The best ways to ensure that creditors, predators, and their attorneys are frustrated in their attempts to impose personal liablility is to set up and maintain the corporation or LLC properly, and to operate it in a legal manner, for legitimate purposes. Our full-service entity formation packages and California Corporate Counsel Program corporate maintenance package are designed to assist with these matters and preserve maximum limited liability and tax advantages.
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