Most, if not all, of the fitness club owners that we have worked with have recognized the value in separating the assets of the business from their personal assets. To do so, most form either a corporation or a limited liability company through which to operate their business. Under corporate law, a properly formed and operated limited liability company or corporation generally offer its owners limited liability protection for the debts and obligations of the business, such that an owner’s losses are limited to their investment in the business. As a result, many believe that by forming an entity, this separation and protection of their personal assets is guaranteed.
Unfortunately, like all rules, there are exceptions. Courts in virtually all states recognize that some circumstances warrant setting aside such liability protection. This is commonly referred to as “piercing the corporate veil” and is only used by courts in unique cases. It should be noted that although “piercing the corporate veil” is often referred to as a doctrine, it is actually an equitable remedy given by courts to creditors and other plaintiffs that are seeking to reach the assets of the owners, or other parties intimately involved with the operation, of an entity when the entity’s assets are not sufficient. The good news is that being aware of the factors that courts analyze when this issue arises can be helpful to ensure that the relationship between you and your business is structured appropriately to mitigate your risk that a court will allow your corporate veil to be pierced.
The Two-Pronged Test
Illinois and Delaware (two states where the entities we often encounter are incorporated) both apply a two-prong test for piercing the corporate veil. This is representative of the test employed by most states. Under this standard, a plaintiff must generally show (1) that the parent and the subsidiary entities acted as a single economic unit and (2) use of the subsidiary to engage in some fraud or misconduct so that respecting the liability shield would cause an inequitable result.
The first prong of the test is sometimes referred to as a “Unity of Interest and Ownership” analysis, which essentially looks at the level of separation between the owner(s) of the entity and the entity itself. Specifically, the court is looking to see if the facts support the notion that the entity was operated as the owner’s “alter ego” or in other words, whether the owner was treating the company’s assets as its own. The court is less likely to respect the separateness between the entity and its owner(s) (or a parent and its subsidiary) if the owner (or parent) itself did not respect such separateness in the operation of the entity.
In connection with this analysis, the court will examine all of the facts of the relationship between the owner(s) and the entity. Although there is not one factor that has been cited as dispositive of a court’s outcome on this issue as this is a true “facts and circumstances” analysis, some of the factors that courts have examined include the following:
- Comingling of funds between the owner’s account and the entity’s account;
- The failure to follow statutory formalities for incorporating and transacting corporate affairs;
- Undercapitalization, meaning that the entity did not have sufficient cash to pay its debts when they were due;
- Failure to provide separate bank accounts and bookkeeping records for the entity; and
- Failure to hold regular meetings of the directors or managers of the entity.
The second prong of the test applies an “injustice” or “fraud” analysis, which examines whether the circumstances are such that an “adherence to the fiction of a separate entity would promote injustice or inequitable circumstances.” As one commentator notes, this category can be seen as “a general catch-all prong which allows courts to disregard a legal entity when they feel like someone has complied with the letter, but not the spirit of the law.” This could involve making misrepresentations about the corporation's financial status, promising that the corporation will perform its obligations while knowing that this is impossible (or intending to do otherwise), or making representations that would lead a creditor to believe that someone, other than the corporation, stands behind the debt or obligations. This could also include other, less obvious actions by the owner.
It is important to note that courts may react differently to a plaintiff with a contract claim who is attempting to pierce the corporate veil than a plaintiff with a tort claim. Some courts have even held that claims for breach of contract present insufficient circumstances to pierce the corporate veil. The rationale for such result is that a plaintiff with a contract-based claim voluntarily entered a relationship with the defendant and therefore could have conducted more thorough due diligence or obtain additional guarantees if necessary. Therefore, the “injustice” prong of the test noted above is less compelling where a contract claim is involved. On the other hand, courts are more inclined to consider piercing in tort cases because as a general matter, the plaintiff did not enter a relationship with the defendant voluntarily.
As I mentioned earlier, the power of understanding the concept of piercing the corporate veil, and the rationale for why courts would permit it is that an owner can minimize their risk by structuring and operating the business entity in an appropriate manner to support the viability of the corporate shield. We now turn to a few practice tips that an owner should utilize to place itself in the best possible position in the event that this issue arises.
- Observe Corporate Formalities. Admittedly as a lawyer, this is one of those pieces of advice that is nice to say but often is confusing to people. So what does this really mean? This means that if your business has a board of directors (or board of managers in the LLC context), you should document your meetings and keep minutes of such meetings to show that decisions were made. Also, you should issue yourself an interest in the entity when you contribute your initial capital. To this end, you should have governing documents such as a Limited Liability Company Agreement (even if it is fairly straight-forward and brief) or bylaws.
- Keep Separate Records and Bank Accounts. A court will look to see if you treated the entity as truly separate. Do not use the business account as your personal piggy bank. You should set up a bank account for the entity, contribute all profits into such account and pay all expenses out of such account. Further, you should keep separate financial records and avoid borrowing from the company to pay personal expenses. It is important to note that from the onset of the entity’s formation, it should have enough capital in its account to pay its debts as they become due.
- Conduct the Affairs of the Entity At Arms-Length. The easiest way to think about this is to say ask yourself “what would this transaction look like between two unrelated parties”. For example, in the event that you own equipment personally and would like to contribute that to the entity as a capital contribution, make sure that such transfer is well documented. Additionally, if you have multiple entities and one entity provides services to the other, those services should be provided subject to a contract or an MOU.
- Consider the “branding” of the entity to customers and creditors. The public should be aware that your business is separate from you. Therefore, if you have business cards, be sure to use the business name and to present yourself to creditors and customers under the guise of the business. This issue often arises in the personal training context where a trainer sets up a single member LLC, directs clients to make payments to such entity but then other than that, does not emphasize that there is a separate business. This concept really pertains to the second prong of the test mentioned above relating to “injustice” or “fraud”. It is your job to make it clear to the world that a separation exists between you personally and your business so that a third party cannot claim down the line that they were unaware of the corporate structure or acted in reliance on your misstatements regarding the available assets.
As discussed, a court’s decision to pierce the corporate veil generally results not from a single factor, but rather some combination of them plus an overall element of injustice or unfairness. While unfortunately there is no guarantee that the business debts and obligations will remain separate from your personal assets (or from the assets of a parent company), an owner would be well-served (1) to maintain and document the level of separation between the entity and owner by treating the entity as distinct and (2) to be candid to third parties about the existence and structure of the entity. It is the steps that you take now with respect to your ownership that will either support or reject the appropriateness of piercing the corporate veil of your business in the future.