One of the most attractive features of a corporation is the ability of a shareholder to invest in the business without facing personal risk for the actions and debts of corporation. But this limited liability is not absolute. The doctrine of ignoring the corporate form and holding shareholders accountable is commonly known as “piercing the corporate veil”.
One method courts use to determine if corporate protections should be set aside is the alter ego test. Here, shareholders can be held personally liable when there is such a unity of interest between the corporation and the shareholders that they are essentially one in the same, and that some injustice would occur if the shareholders were permitted to escape personal liability.
When applying this test, courts will consider a number of factors, such as: whether corporate funds were used for personal use; whether personal and corporate property were held separately; whether stock was properly issued; whether the shareholders kept corporate records and adhered to legal formalities; and whether the corporation was adequately capitalized.
Courts have also used inadequate capitalization or undercapitalization as the sole means to pin liability on shareholders. Measuring the adequacy of capital is no easy task. Courts will look to whether capitalization is unreasonably small or illusory given the size, nature, and liabilities of the business. Although no bright-line rule has been set, officers and directors would do well to consult their financial advisors, prepare budgets and financial forecasts, and examine the need for liability insurance.
In short, to protect yourself from personal liability you must see to it that the corporation is ran on the up-and-up. Make sure that you and your fellow shareholders treat the corporation like a separate entity. See to it that the business has a reasonably strong capital structure. Observe all of your corporate formalities. Fulfill your tax obligations. Keep good records. And do not, under any circumstances, treat corporate property like personal property, or vice versa.
* LLC members should also take note. In California, much of the above also holds true for LLCs.
