Avoiding Personal Liability if others try to Pierce the Corporate Veil
Usually, corporation owners and limited liability companies can’t be held personally liable for business liabilities. Unfortunately, in some circumstances, courts can allow creditors to “pierce the corporate veil,” and access a business owner’s personal assets. It is crucially important for business owners to understand when, why, and how their personal assets might become vulnerable to any business liabilities. The two major factors the court looks at are the undercapitalization of the company, and using the company as an “alter ego.”
Undercapitalization and Alter Ego
Arizona law mandates that corporations be adequately capitalized when formed, and throughout the corporation’s life. There is no exact limit or amount required, but the spirit of the law is to protect creditors and any other parties with whom the company has liabilities. “Alter Ego” is a term referring to when the owner treats the company as a partnership, personal asset, or sole proprietorship instead of a separate business entity. As such, it is crucial to follow these instructions to avoid loss of personal assets by piercing of the corporate veil:
- Maintain sufficient business capitalization throughout the company’s life.
- Participate in the required formalities for the business entity.
- Don’t interweave business and personal assets or activity.
- Make clients aware of the corporation or LLC’s status.
- Record all business actions.
1. Maintain adequate capitalization throughout the life of the company.
Arizona law mandates that corporations be adequately capitalized when formed, and throughout the corporation’s life in order to respond to claims and liabilities against the corporation. There is no exact dollar amount required, but usually the test is when the company begins. The best practice is to be adequately capitalized right when the business starts, then continue keeping the company adequately capitalized through the company’s lifetime, keeping in mind current and foreseeable liabilities. With a sufficient cushion of capital in the company, business owners will be protected from having their own personal assets accessed when others try to pierce the corporate veil.
2. Participate in the required formalities for the business entity.
Corporations have requirements they must complete. Even though LLC law is not as strict, it is still a good idea to follow the same requirements. The courts may investigate a company that is not following the requirements as a possible alter ego. If the court deems the company a partnership or sole proprietorship, then the court will treat the company as if it was a partnership or sole proprietorship by permitting the corporate veil to be pierced, thereby exposing the owners to personal liability.:
Corporation formalities you should follow:
- Create, uphold, and revise bylaws.
- Distribute shares of stock to stockholders.
- Keep a stock transfer updated.
- Hold initial and annual meetings with both shareholders and directors
- Keep annual filings, taxes, and fees up to date with the state of incorporation.
LLC formalities you should follow:
- Give all owners a membership certificate.
- Maintain a membership transfer ledger.
- Hold initial and annual meetings with managers and members.
- Maintain all annual filing, taxes, and fees up to date with the state of incorporation.
3. Avoid mixing personal and business assets and activities.
A business owner needs a savings accounts, checking account, and credit cards all specifically dedicated to the business. Business accounts should never pay for personal expenses, and personal accounts should never pay for business expenses. Doing this protects the business owner against accusations that they are using the business as an alter ego.
4. Make clients aware of the corporation or LLC’s status
Business owners need to let their clients know about the status of the corporation or LLC. Any business cards should clearly denote whether the company is a corporation or LLC. All contracts and documents should be to and by the business and not the owner. Invoices should bear the company’s name. This will help protect against accusations of alter ego where clients or creditors claim they did not know that the company was a corporation or LLC.
5. Record all business actions.
Business owners should record everything that the business does. They should record any formalities they engaged in, any evidence of separate accounts for personal activities and business needs, and any documents proving consistent maintenance of adequate business capital. These documents can be used as proof to protect an owner’s personal assets if another party tries to pierce the corporate veil.
A prudent business owner should comply with all regulations and formalities under corporation law, treat the company as a separate entity, and document every action. The best course is to always seek out the help of a professional attorney at the beginning of the company, and throughout its life as necessary. The Mesa Arizona business attorneys at Denton Peterson assist clients with these and many other business legal needs.
1930 N. Arboleda, Suite 200
Mesa, AZ 85213