Arizona Contractor & Community
LLCs and corporations: How to preserve your liability protection
Legal doctrines called “piercing the corporate veil” and “alter ego” allow liability to reach individuals and entities outside a corporation or LLC. Attention to a few important details can help keep you protected.
Corporations and limited liability companies (LLCs) are the most common types of business entities. Both allow for flexibility in management and governance, and both provide limited liability for the owners.
But many business owners are unaware that, if they make certain mistakes, they can forfeit their liability protection and expose themselves to personal liability for the company’s debts and conduct.
The law calls this theory “piercing the veil” to create “alter ego” liability. Essentially, in a lawsuit against a corporation or LLC, a court may pierce through the “veil” of the legal entity to reach owners that it deems are the “alter egos” of the entity.
Alter ego and veil-piercing problems can arise when the interests of the entity and its owner(s) are so unified that they are essentially indistinguishable from each other.
The applicability of this legal theory will always depend on the facts of a case, but personal liability can be imposed if another party can prove that:
there was a “unity of control” between the corporation/LLC and another individual or entity, and
limiting liability to the corporation or LLC would promote a “fraud or injustice.”
Unity of Control. Unity of control issues can arise when an owner makes management or operational decisions for the corporation/LLC that favor the owner’s interests over those of the entity. This goes beyond the actual management of the business and often includes behaviors such as:
creating common ownership between the corporation/LLC and another entity;
using common office space between the corporation/LLC and another entity, or using the corporation/LLC office space for personal purposes;
financing the corporation/LLC entity exclusively through another entity or individual;
paying salaries or other expenses of the corporation/LLC through another entity or individual;
intermingling corporation/LLC funds with the funds of another entity or individual;
failing to maintain separate corporate/LLC formalities required by the operating agreement or bylaws;
advertising through the corporation/LLC with the same materials that were created for another entity;
using a corporation/LLC for the business but titling all assets and equipment under other names or entities; or
otherwise merging corporation/LLC activities with personal activities or those of another entity.
Fraud or Injustice. In most cases, a court will pierce the veil only if a failure to do so will result in an injustice. Against that backdrop, courts generally look at the situation as a whole to determine whether a fraud or injustice would be perpetuated by preserving the owner’s liability protection.
For that finding to exist, it is not necessary for the court to find that the corporation or LLC was formed with the intent to commit fraud. Rather, if observing the corporate form would (a) frustrate a plaintiff’s efforts to protect their rights and (b) allow the owner to escape liability for fraudulent acts committed in the name of the corporation or LLC, a court will likely find the veil should be pierced.
Takeaways. To preserve the liability protection that you sought to achieve in creating your corporation or LLC:
adopt and follow good business practices;
in making business decisions for the entity, ensure that those decisions support the entity’s interests;
keep the entity’s cash and other assets separate from your personal cash and assets;
maintain accurate and thorough records that show a clear distinction between your personal affairs and the operations of the entity;
make business decisions by the formalities required by the entity’s operating agreement or bylaws; and
if those formalities are found to be unworkable, amend the operating agreement or bylaws so that they are workable.
If you have questions about the overall integrity of your entity’s liability protections or are concerned about a particular source of liability, seek the guidance of an experienced business attorney.