How Business Owners Can Avoid Alter Ego Liability
Under the alter ego doctrine, the legal liability protection of a corporation or limited liability company can be set aside by a court if it is found that the corporation or LLC was used as a mere shell by persons or other entities for a wrongful or inequitable purpose.
If a court determines that a company is not separate from its owners, then the liability protection of the corporation or LLC is pierced. As a result, the owners’ personal assets can be used to pay a legal judgment.
Some factors a court will consider in determining whether to pierce the veil are:
- Significant lack of funding for the corporation or LLC;
- Failure to observe formalities (meetings, minutes, resolutions etc.);
- Commingling assets with individuals or other entities;
- Treatment by an individual of the assets of the company as their own;
- Siphoning of the company’s funds by the owners;
- Non-functioning officers, directors or managers;
- Failure to pay dividends/distributions;
- Concealment or misrepresentation of members;
- Absence or inaccuracy of financial records;
- Use of the company as a front for personal business;
- Failure to maintain arm’s length relationships with related entities; or
- Manipulation of assets or liabilities to concentrate those assets or liabilities;
This list is not exhaustive but is intended to provide a general idea of the types of conduct to avoid.
Normally, alter ego allegations are raised right away when a lawsuit is filed against the corporation or LLC. Keep in mind that alter ego allegations can also be raised after a judgment is entered by the court against a corporation or LLC. In this case, the court may amend the judgment to include a principal of the entity if alter ego considerations are present and the principal controlled the litigation on behalf of the entity.
Courts have also found a manager of a LLC liable for the debts of the LLC when a manager personally engages in fraudulent or criminal conduct when performing their duties as manager. Managers need to sign contracts in their capacity as managers of the LLC (include title and LLC’s name) in order to avoid claims of personal liability.
Forming your business as a corporation and LLC can offer the benefits of limited liability, favorable tax treatment, and managerial flexibility. However, there are many guidelines that must be followed in order to receive and preserve those benefits. It is also important to avoid the types of conduct mentioned above so that the desired benefits can be obtained while avoiding personal liability of the principals of the entity.