If you have one or more corporations or LLCs, this subject should be of importance to you. The general rule in every state is that a creditor of a corporation or LLC cannot reach the assets of the owners unless the owners have signed a personal guarantee, or unless the creditor can pierce the corporate veil.
Courts in every state generally uphold the liability protection offered by a corporation or LLC, and they rarely are willing to pierce the corporate veil. A two-part test has been developed by the Utah Supreme Court to assist in determining when to disregard a corporation or LLC. ”[I]n order to disregard the corporate entity, there must be a concurrence of two circumstances: (1) there must be such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist, viz., the corporation is, in fact, the alter ego of one or a few individuals; and (2) the observance of the corporate form would sanction a fraud, promote injustice, or an inequitable result would follow.” (Envirotech Corp. v. Callahan, 872 P.2d 487, 499 (Utah App. 1994)).
There are slight differences from state to state, but courts will typically look at the following factors to determine if a corporate veil can be pierced: (1) is there commingling of funds between the entities, (2) is the management the same, (3) is the ownership the same, (4) do the entities have separate bank accounts and accounting records, (5) do the entities have their own operating agreements, (6) is their a unity of purposes, assets, or operations, (7) does one entity exert dominion over the other, (8) is the entity undercapitalized for its operating needs, (9) is there a failure to fulfill corporate formalities, etc.
After reviewing applicable case law, the following are my tips to avoiding a piercing of your corporate veil:
- Each entity should have its own bank account, keep its own accounting records, collect its own income, and pay its own bills. It is possible to have another entity provide management services (such as collecting income and paying bills) if a written management agreement is in place and if proper allocations and reimbursements are made.
- Corporations should have an updated corporate book with bylaws, organizational meeting minutes, a stock ledger, updated stock certificates, and minutes of annual meetings of shareholders and directors. LLCs should have an operating agreement and they may strengthen their position by having resolutions or minutes of manager meetings although these are not required. Entities must be operated in accordance with the rules set forth in the bylaws or operating agreement.
- Related party transactions should be documented with written leases, promissory notes, purchase agreements, etc, and the terms should be typical of an arms-length transaction.
- Different entities should have differences in the identify of their officers, directors or managers. In a family setting, you could have one spouse manage one entity and another spouse manage another entity. After all, who could argue that a husband and wife have such a unity of interest that the separate personalities no longer exist and one is the alter ego of the other?
- Any use of assets, employers or resources of one entity by another entity should be compensated or reimbursed.
- Each entity should have sufficient capital to meet its operating needs.
- Each entity should have its own assets and resources which are allocated to its independent purposes.
- Most entities should have an annual meeting with an outside CPA and attorney to discuss tax and business planning issues, update corporate documents, review buy sell agreements and leases, check on asset titles and corporate renewals, and review the factors necessary to avoid a piercing of the corporate veil.