10 Apr 2018 Your Alter Ego Liability under California Law
Many advantages come with the formation of an entity in a limited liability format. One of the primary advantages is the limitation on personal liability for the debts, obligations, and other liabilities that can happen throughout the operation of a business venture. This limited liability protection generally works by protecting members of an LLC and shareholders in a corporation from facing personal liability due to their various business endeavors.
While limited liability is generally a great advantage for members and shareholders, there are a few instances where it can be disregarded, leaving individuals stuck with their company’s debts, obligations, and other liabilities. Those instances are rare, and with careful planning and compliance with corporate formalities, are avoidable in all cases.
Piercing the Corporate Veil
The primary tool used by creditors to get at the assets of a shareholder is known as piercing the corporate veil under the alter ego doctrine. This is a legal claim that creditors can make against a shareholder in order to reach the shareholder’s assets. If successful, they can bypass the limited liability protection afforded by the corporate form.
Admittedly, this tool is a drastic one, and should only be implemented sparingly by the courts; however, in a world where litigation is becoming more and more common, and creditors are becoming more and more aggressive about collecting debts, the alter ego doctrine is a concept with which every shareholder should be familiar.
Alter ego itself refers to a situation where a shareholder or director of a corporation acts in such a way that the corporation is not a corporation at all, but rather an “alter ego” of the shareholder or director who uses the entity for his or her own purposes. To make a claim for alter ego under California law, a creditor would have to prove two key elements:
1. There is a unity of interest and ownership between the company and its owner; and
2. It would be unfair to treat the underlying acts as those of the corporation alone.
As you can see from these two elements, the doctrine is a bit vague, which is why California courts have developed many factors over the years that they will apply to a corporate veil and alter ego case.
Alter Ego Factors
• The commingling of funds or assets of the corporation and the shareholders;
• Abuse of the corporate form by not holding meetings, allowing the directors to vote, and not following corporate by-laws;
• A lack of issuing stock by the corporation;
• A lack of capital to properly run the corporation; and
• Using a corporation to hide or encourage illegal activities, fraudulent transactions, or both.
These are just some of the many factors a court will examine in an effort to decide whether a corporate veil will be pierced, and the shareholders made liable for the claims against a corporation.
In California, a member of an LLC shall be personally liable to the same extent as a shareholder of a corporation under the alter ego doctrine. This means the manager, member, or another LLC (where two LLCs are under common ownership) can be liable for the debts, obligations, and other liabilities of the company due to a failure to respect the company’s separate identity.
The company’s debts, obligations, and liabilities do not become those of a member or manager, however, due to the member acting as a member or the manager acting as a manager. Instead, the alter ego doctrine is usually applied where there is a: (1) failure to complete formation of the company; (2) failure to properly capitalize the company; (3) use of company assets for personal use; and/or (4) commingling of company funds with personal funds.
Standards for Veil Piercing
The standards for veil piercing are high. Courts impose a presumption of the company’s separate existence, which the plaintiff has the burden to overcome. Thus, as long as you treat the company as a business entity, separate from yourself in your individual capacity and any other business under common ownership, there is a low likelihood that a plaintiff will prevail on the merits.
If you have concerns about alter ego liability or other questions about the law, be sure to contact us. At the Royse Law Firm, we dedicate a large portion of our practice to advising the founders of corporations and LLCs in California so they can avoid these types of legal issues.
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