One of the most significant advantages of forming a corporation is the protection from liability that is offered by this structure. A corporation is treated as a separate person from its directors and shareholders under the law. Shareholders can expect to avoid personal liability if they follow specific rules, otherwise known as corporate formalities. The alter ego doctrine applies when a corporation fails to conform to these corporate rules.
A court may determine that the corporation is devoid of a distinct identity from a director or shareholder (that it is essentially an alter ego) and thereby pierce the corporate veil to find that the transgressing party is personally liable for corporate debts. In general, the judiciary has developed a test for alter ego liability which requires both: (i) a unity of interest, in which the separateness of the corporation no longer exists because of the unity of interest between the corporation and the individual whose conduct is being scrutinized and (ii) the commission of a fraud or promotion of injustice if the corporate veil is not lifted.
In California, the pivotal case of Associated Vendors, Inc. v. Oakland Meat Co. addresses the concept of alter ego liability. The factors discussed therein have been used to determine whether the first prong of the test -a unity of interest- is satisfied. While these elements are not exhaustive or conclusive, they have been instrumental for courts in deciding this issue. Some of the most significant factors include:
- Commingling of personal assets with corporate assets or handling corporate assets in any way that resembles personal use;
- Failure to comply with state laws concerning legal formalities, such as keeping minutes;
- Complete ownership of stock by one entity;
- A stockholder or director presenting himself as incurring personal liability for corporate debts;
- Treating the corporation as a shell entity for the performance of other functions;
- Inadequate capitalization of the corporation; and
- Diverting corporate assets to avoid personal liability.
There are a number of steps a corporation can take to reduce the likelihood that a court will pierce the corporate veil. These include maintaining the distinct identity of each entity of the businesses through proper books and records, following state laws relating to corporate formalities, and ensuring that directors and shareholders present themselves as separate from the corporation.
Contact Shane Coons at 949-333-0900 or visit his website at www.ShaneCoonsLaw.com to find out more about his practice.