One of the most attractive features of incorporating a business entity is the limited liability protection accorded to its corporate directors, officers, and shareholders. When incorporating a business, a corporation will be viewed in the eyes of the law as an entity entirely independent and distinct from its owners, the corporate shareholders. The concept of limited liability limits risk exposure of owners and shareholders to the conduct and actions of the corporation.
Incorporating a Business
The concept of incorporating a business rests behind the corporate veil, which entitles a company to function independently from its members. This protective shroud provides a shield for owners and shareholders against personal liability from corporate debts. This means that in most situations creditors have no claim on the personal assets of individual entrepreneurs in the unlikely event that the corporation goes bankrupt.
However, the corporate veil doctrine has its limitations. When corporate members fail to perform their responsibilities and neglect to maintain corporate formalities and protocols, the protective veil can be lifted, through a process called piercing the corporate veil. The doctrine of piercing the corporate veil means that the individual corporate officials and owners can be held personally accountable for the debts and obligations incurred by the corporation.
Piercing the Corporate Veil – When Does it Happen?
The court invokes corporate veil piercing when the corporate principals neglect to maintain the distinct characteristics between the corporation and the shareholders. In other words, they fail to correctly maintain the formality of the corporation. Piercing the corporate veil is a judicial act that allows the creditor to puncture the veil of limited liability protection conferred upon corporate officials owners. The court holds those people personally responsible for corporate obligations.
There are two theories behind the concept of piercing the corporate veil: the alter-ego theory and the instrumentality theory. The alter-ego, or, other self-theory, examines whether or not the owner managed the operation of the incorporated business as a separate legal entity. Under the instrumentality theory, the court scrutinizes the corporation to see if it was used by its owners as a mere instrument for their own personal benefit.
Piercing the Corporate Veil – Factors to Consider
There are several factors that can most frequently lead to corporate veil piercing. One is the failure of corporate members to exercise and maintain corporate formalities, such as conducting regular board of director and shareholder meetings, recording meeting minutes and filing proper corporate documents, as well as failure to adopt corporate bylaws and issuing shares at the time the corporation was formed.
Another factor that may allow the court to ignore the separate legal entity characteristics is the failure to acquire and maintain adequate funding to sustain normal business operations or undercapitalization after incorporating a business.
Courts may disregard the corporate existence when the funds and assets of a corporation are commingled with that of corporate officers, directors and shareholders. Neglecting to segregate corporate funds from personal assets of controlling shareholders, and the illegal diversion of corporate funds and assets are also basis for corporate veil piercing.
Piercing the Corporate Veil – Application by a Court
The primary goal of the court in applying the corporate doctrine of veil piercing is to achieve an equitable result. Although applied in rare and exceptional circumstances, the outcome of lifting the corporate veil can be extremely harsh on those involved with the corporation. Hence, it is imperative that the separate legal entity status of a corporation and its owners are recognized and respected, thus maintaining the limited liability protection granted to shareholders espoused by an incorporated business entity.
Piercing the Corporate Veil – Prevention
To prevent the harsh effects of piercing the corporate veil, let us help you in legal matters. Gale and Vallance is an expert in incorporating a business and provides all the necessary attorney services for your business.