Thursday, September 6, 2018
When Can A Corporate Shareholder Be Held Liable For Corporate Debts and Liabilities?
One of the reasons for the formation of a corporation is to achieve liability protection. Liability of corporate shareholders is limited to the extent of their individual investment in the corporation. In a farm and ranch setting, while a corporation may not actually be utilized as the operating entity, it is commonly used to hold operating assets as a means of shielding the shareholders from personal liability against creditor claims arising from operations.
But, creditor protection is not absolute. In certain circumstances the corporate “veil” can be “pierced” with the result that a shareholder can be held personally liable for corporate liabilities.
Corporate veil-piercing – that’s the topic of today’s post.
Factors for “Piercing”
Corporate “veil piercing” is generally a matter of state law. A state’s corporate code sets forth the rules for properly forming a corporation and the ongoing conduct of the corporate business. It is critical for a corporation and its shareholders to follow those rules. For instance, shareholder limited liability can be lost if the corporation is not validly organized in accordance with state law. In addition, to maintain limited liability the corporation must comply with certain corporate formalities such as conducting an annual meeting, filing an annual report with a designated state office, and electing directors and officers. If these corporate formalities are not complied with, limited liability for shareholders is sacrificed.
Also, a reasonable amount of equity or risk capital must be committed to the corporation. Shareholder limited liability is lost if the corporation is inadequately capitalized. Courts will “pierce the corporate veil” unless a reasonable amount of equity capital is committed to the business to serve as a cushion to absorb the liability shocks of the business. See, e.g., Dewitt Truck Brokers v. W. Ray Flemming Fruit Co., 540 F.2d 681 (4th Cir. 1976).
Illustrative Cases on Veil Piercing
The following cases are a small sample that show the various ways in which corporate veil piercing can arise:
- In Juniper Investment Co v. United States, 338 F2d 356 (Cl. Ct. 1964), a personal holding company’s separate existence was disregarded because it acted as the alter ego of the shareholders.
- Listing corporate assets as those of the shareholder on the shareholder’s personal loan application resulted in the court finding that the corporation was merely created for the taxpayer to avoid tax and was not a separate entity from the shareholder in Wenz v. Comr., T.C. Memo. 1995-277.
- In Foxworthy, Inc. v. Comr., T.C. Memo. 2009-203, the court held that the corporation at issue was the taxpayer’s alter ego that couldn’t be disregarded for tax purposes. The court pointed out that the taxpayer was neither an owner, director or corporate employee. Even so, the taxpayer had complete control over the corporation and used the corporation to buy the taxpayer’s personal resident and maintain it. The court noted that the corporation had no real business purposes and was used in an attempt to convert personal living expenses into deductible business expenses.
- Veil piercing was the result where a corporation’s funds and a shareholder’s funds were comingled and the shareholder controlled and managed the corporation’s accounts as his own. Pollack v. Comr., T.C. Memo. 1982-638.
- In Pappas v. Comr., T.C. Memo. 2002-127, the corporate veil was pierced because there was no real distinction between the taxpayer and the corporation. The taxpayer used corporate funds for personal expenses, the corporation didn’t file federal or state tax returns. In addition, corporate formalities were ignored, and the corporation did not have a separate office apart from the taxpayer’s home address. Also, the taxpayer was the only corporate employee and corporate records were not maintained.
In Woodruff Construction, L.L.C. v. Clark, No. 17-1422, 2018 Iowa App. LEXIS 765 (Iowa Ct. App. Aug. 15, 2018), the defendant formed a corporation and filed articles of incorporation in 1997. The corporation was reincorporated in 2001 after an administrative dissolution. The corporation was engaged in the business of biosolids management. The defendant was the sole owner and director of the corporation along with being the corporation’s secretary and treasurer. The plaintiff contracted with a small town to be the general contractor during the construction of a wastewater treatment facility for the town. In early 2010, the plaintiff contracted with the defendant for lagoon sludge removal. The defendant began work, but then ceased work after determining that project would cost more to complete that what the contract was bid for.
In 2012, the plaintiff sued for breach of contract and obtained a judgment of $410,066.83 plus interest in 2014. The corporation failed to pay the judgment and the plaintiff sued in 2015 to pierce the corporate veil and recover the judgment personally from the defendant. The trial court refused to pierce the corporate veil and also denied a request to impose a constructive trust and equitable lien on the corporate assets. The plaintiff appealed the denial of piercing the corporate veil.
The appellate court determined that the plaintiff had failed to establish that the corporation was undercapitalized – it had assets and was profitable. The plaintiff also did not show that the corporation was undercapitalized at the time it entered into the contract with the plaintiff. There also was no evidence showing that the corporation changed the nature of its work or engaged in an inadequately-capitalized expansion of the business. It was also unclear, the appellate court noted, that the capital transfers from the corporation to the defendant rendered the initial adequate capitalization irrelevant. Thus, the plaintiff failed to establish that the corporation was undercapitalized to an extent that merited piercing the corporate veil.
However, the appellate court noted that the evidence illustrated that the defendant commingled personal funds with corporate funds. The defendant used corporate funds for personal purposes, and also failed to maintain separate books and records that sufficiently distinguished them from the defendant personally. In addition, the appellate court noted that the corporation did not follow corporate formalities. The corporation had been dissolved administratively by the Secretary of State in 1998 due to the failure to file a biennial report, but the corporation continued operations during the time it was dissolved as if the corporation were active. When the new corporation began in 2001, no bylaws, corporate minute book or shareholder ledger were produced. In addition, the new corporation (operating under the same name as the old corporation) was administratively dissolved three times for failure to submit the biennial report (the corporation used the statutory procedure to apply for reinstatement each time). The appellate court determined that the corporation was not considered by the defendant to be a separate entity from himself. Accordingly, the appellate court reversed the trial court and allowed the corporate veil to be pierced and the defendant to be held personally responsible for the judgment.
To obtain creditor protection that the limited liability feature of a corporation can provide, it’s critical to follow corporate formalities and respect the corporation as an entity distinct from the shareholder. Failure to do so can result in personal liability for corporate debts and obligations. With machinery, equipment, livestock and unique features on farm and ranch land, achieving liability protection for farmers and ranchers is a big deal. Respecting the corporate entity is key to achieving that protection. Good legal counsel can make sure these requirements are satisfied.