One of the main benefits of doing business in the corporate form is the limited liability enjoyed by shareholders. Since a corporation is an entity separate from its shareholders, a person making a claim against a corporation can look only to the entity to satisfy the claim.
A major exception to this limited liability rule occurs when the corporation is considered to be an “alter ego” of its shareholders. When this happens, the corporate separateness may be disregarded.
Disregarding the corporate entity is called “piercing the corporate veil.” When the corporate veil is pierced, shareholders can then be held personally liable for the corporation’s debts. Even the owner of a single share of stock can be liable for all the corporation’s debts.
Corporations and shareholders should take steps to properly maintain the corporate separateness. These steps can be summarized as follows: observe corporate formalities, maintain separate existence and adequately capitalize the corporation.
Observe Corporate Formalities
When someone tries to hold a shareholder personally liable for a corporate debt, courts look to the formation and operation of the corporation to see if the organizers took the corporate form seriously. Thus, corporate formalities must be observed from the moment the entity is formed. Corporate formalities that must normally be followed include:
- electing directors and officers;
- issuing stock;
- holding meetings of shareholders and directors and maintaining minutes of the meetings; and
- keeping accounting records.
Maintain Separate Existence
When shareholders ignore the corporation’s separate identity, the corporate veil may also be pierced. Shareholders can help maintain separate corporate existence by:
- not commingling corporate and shareholder funds;
- not using corporate funds to pay debts of shareholders;
- making sure corporate funds flow through bank accounts in the corporation’s name; and
- thoroughly documenting all transactions between the corporation and its shareholders, officers and directors.
Adequately Capitalize the Corporation
A major basis for holding a shareholder personally liable for a corporate debt is inadequate capitalization. A corporation must have sufficient assets to carry on its business. Corporations and shareholders can help assure there is adequate capital by:
- preparing a business plan to estimate capital needs;
- making sure enough of the capital is equity; and
- periodically reviewing whether additional capital is needed.
The above measures do not guarantee that a corporate entity will not be pierced. But they will help if someone tries to do so. This is an area where preventive measures can help avoid costly lawsuits.