Beware Your Alter Ego
Corporations have existed for centuries. One way they promote economic activity is by allowing stockholders to limit their personal liability for corporate debts to the amount of their individual investments in the corporation (“limited personal liability”).
Consequently, entrepreneurs often form new corporations to run their new businesses. But they should be careful – sometimes courts ignore the corporate entity and hold an entrepreneur liable for all of the corporation’s debts!
This result often is called “piercing the corporate veil“. It also is referred to as the “alter ego” doctrine, on the theory that the corporation merely was the alter ego of the entrepreneur.
Alter ego typically arises when a plaintiff sues an insolvent corporation and needs another defendant – the entrepreneur – who can pay the hoped-for award of damages. California courts apply the doctrine when (1) there is a unity of interest and ownership such that the entrepreneur and the corporation are no longer separate entities and (2) adhering to the fiction of a separate corporate entity would sanction a fraud or promote injustice. Minifie v. Rowley (1921) 187 Cal. 481, 487.
In determining whether there is a unity of interest and ownership, courts look at such factors as:
- Whether corporate and individual funds were commingled
- Whether corporate funds were used for personal purposes
- Whether adequate corporate records and minutes were kept
- Whether the corporation was merely a shell for the entrepreneur’s activities
- Whether the corporation was severely undercapitalized
Harris v. Curtis (1970) 8 Cal.App.3d 837, 840-41.
The last factor merits elaboration. Many new companies are underfinanced. However, if the invested capital “is illusory or trifling compared with the business to be done and the risk of loss,” the court may apply the alter ego doctrine. Harris at 842.
So if you plan to start a company and want to use a corporation to limit your personal liability, be sure to hold personal assets separate from corporate assets; keep up with all required corporate formalities; and provide enough capital to have a reasonable shot at satisfying the corporation’s business needs.
Related posts:
- Avoiding “Alter Ego” Problems: A To-Do List
- Corporate Suspension and Personal Liability are Two Different Things
This blog does not provide legal advice and does not create an attorney-client relationship. If you need legal advice, please contact an attorney directly.
Dana Shultz is a business-savvy lawyer located in Northern California's San Francisco Bay Area (in the East Bay, near Oakland) who has in-depth knowledge of law, business, technology, and the needs of startup and early-stage companies.
With regard to your comment on my answer to the Q on piercing, plz read my answer a little more carefully. I said an “LLC provides a bit better protection that a corp” because of piercing “due to failure to comply with corporate procedures.” In the above you list lack of “adequate corporate records and minutes” as one factor courts consider.
While this sometimes seems like a makeweight for a court about to pierce a corp, the fact remains that LLC’s have no requirements for minutes to comply with. This must reduce their potential for piercing to at least a small extent. A couple of years ago I had a case on piercing LLC’s. Extensiver nationwide research at that time revealed no case where a court pierced an LLC. LLC’s are still young. As time passes such a case may appear, but I still will advise my clients that the risk is less for an LLC than for a corp for piercing.. Best practice of course is to capitalize well, have insurance and maintain separate books, whether a corp or an LLC.
Keith Martin
@B. Keith Martin
Thanks for the comment and clarification.