Reverse Piercing and the Myth of Limited Liability – Beware of the Alter Ego!

A novel situation has presented itself in recent court decisions. In 2004, the New York Court of Appeals ruled in favor of granting a new type of remedy, “reverse piercing.” Piercing the corporate veil is a fancy way of saying that the shareholders of an entity are personally liable for the debts and liabilities of that entity. This means that if the entity does not have enough money to pay all debts and liabilities, creditors came attack a shareholder’s personal holdings.

Reverse piercing is different. In a reverse piercing situation, an entity is held liable for the debts and liabilities of its shareholders. This is an amazing theory because the whole point of a limited liability entity is to protect the personal assets of its shareholders and vice versa. In other words, the shareholders and the business are two completely separate entities. However, many of the factors used by the court to determine whether an entity should be pierced are used in determining whether a reverse piercing should take place.

The main inquiry is whether the individual shareholder is the alter ego of the entity. In other words, are the two distinguishable (in a legal sense)? In the New York case, the defendants were sued by two creditors. The defendants contracted to buy a house and formed a corporation for the purpose of buying the house. The defendants, and not the defendant’s corporation, paid the property taxes and mortgage principle and interest on the house. The defendants then deducted the payment of these taxes and mortgage interest from their, and not the corporation’s, tax return. The court concluded that the defendants bought the house in a way to avoid the creditors’ claims, and the defendants utterly controlled and completely dominated the corporation. As such, the court held that the defendants were the alter ego of the corporation, and the house purchased by the corporation (and therefore the property of the corporation) was subject to the creditors’ claims.

Let this be a lesson to all you aspiring entrepreneurs! If you have a corporation, or any legal limited liability entity, make sure that you keep the entities affairs separate from your personal affairs. If you do commingle these affairs, you may be subject to personal liability or, under a reverse piercing theory, your entity may be liable for your personal debts and liabilities.

Piercing the Corporate Veil

Piercing the corporate veil is a fancy phrase that means that somebody or something is attempting to hold the shareholders of a corporation personally liable for the corporation’s debts. Veil piercing is not an easy task and requires many factors to be proven. The main inquiry is, “has the corporate form is being misused?” If it is concluded that the corporate form is being misused, the court will disregard the corporate entity and hold the shareholders personally liable.

Each state has different factors that in considers in determining whether to pierce the corporate veil. It would be inefficient to list all the various laws from all fifty (50) states, however, I will discuss some common factors.

Undercapitalization is a commonly considered by most states. Undercapitalization means that the corporation was not equipped with a reasonable amount of capital for the nature of the business involved. What is reasonable? If there was a clear answer to that, there would not be a need for lawyers! Reasonableness depends on many factors including type of business, size of business, etc. If a corporation is undercapitalized, this weighs in favor of the court piercing the corporate veil.

Another commonly considered factor is the failure to observe corporate formalities. Like I stated in previous posts, failure to observe corporate formalities will tip the scales towards the court piercing the corporate veil. Corporate formalities need to be observed by all corporations (except a close corporation).

Lastly, most courts consider whether a corporation was used to promote fraud, injustice, or illegalities. Let me put it this way, if you use the corporation to engage in illegal activity (for example, defraud somebody out of money or other valuables) the court will most likely pierce the corporate veil.

It is important to note that these are just some of the commonly considered factors. Every state has a different set of factors, therefore, check your local laws. Also, no one factor is controlling. Therefore, veil piercing does not turn on the absence or presence of a single factor. Last, even though no one factor is controlling, the factors are not weighed evenly. Factors such as illegal use weigh more than whether or not corporate formalities were observed.

Once again, this post is intended only to give you a brief overview of some corporate issues and in no way constitutes legal advice or a legal opinion. Always consult a professional before attempting anything stated above.

The Corporation

The corporation is probably the mother of all limited liability entities. The case law is vast and the complexities are many. However, a corporation can be a great business form if you know what the differences between the various corporations are.

As I stated in a previous post, corporations are subject to double taxation. A dollar earned by the corporation is taxed once as a corporate earning and then taxed again upon distribution to shareholders. However, this is not true for all types of corporations. An S-corporation (named after sub-chapter S in the relevant IRS code) is a pass-through entity. This means that the corporation is taxed as a partnership. Therefore, no double taxation! Unfortunately, with benefits come disadvantages. I do not have the code book open in front of me, but I think some of these disadvantages include, amongst other things, limitations of the number of investors you can have (I think you can only have seventy-five (75) investors for an S-corporation), and limitations on who can invest (no other entity, such as another corporation or limited liability company, can be a shareholder).

Keep in mind that when you form your corporation with articles of incorporation, filed with your Secretary of State, you do not form an “S-corporation.” Subchapter S status is received from the IRS, not your state! However, some states require that you state your intention to be an S-corp. in your articles of incorporation. Therefore, check your local laws!

A close corporation is the same thing as an subchapter S corporation, but with stricter limitations (for example, I think some close corporations can only have thirty-five (35) investors). A great advantage exists with close corporations. Close corporations do not have to engage in corporate formalities. Why is this important? When somebody sues the corporation and tries to pierce the corporate veil (meaning the claimant is trying to “pierce the veil of limited liability” and hold the shareholders personally liable), one factor, of many, the court considers in determining whether to pierce is whether the corporation engaged in corporate formalities. If a corporation engaged in corporate formalities (conducted annual meeting, recording minutes, etc.) this supports the conclusion that a corporation did not misuse the corporate form and, therefore, is less likely to have its “veil” pierced. If you have a close corporation, corporate formalities do not have to be conducted, and a court cannot hold that against you should any lawsuits arise.

A closely held corporation is a term of art. There is no special filing or advantage to a closely held corporation. A closely held corporation is one in where the shareholders and the directors are the same people. Usually about five shareholders will exist, and each will also be a director, if not also an officer, of the corporation. In case you are wondering, shareholders elect directors and directors elect officers.

This post is intended to give you a brief overview of some of the corporate forms that exist. Like always, check with a professional before trying to form one of these entities by yourself.

The Types of Business Organizations Part 2

The other type of business organization is the limited liability organization. These entities can take many forms. These forms are: (1) a limited liability partnership; (2) a limited liability company; (3) a limited liability limited partnership; and (4) a corporation. Note that there are various forms of corporations (such as an S-corporation, a close corporation, and a closely-held corporation), but these are conversations for another day.

Like the unlimited liability entities, these limited liability entities have pros and cons. First, and most obviously, these limited liability companies, as the name suggests, limits your liability. You are liable (some exceptions apply such as piercing the corporate veil) only up to the amount of your investment. Therefore, if you investment two thousand dollars ($2,000) into a corporation, and the company has debts, you are only liable up to your two thousand dollar ($2000) investment.

Second, all of these entities, except a corporation, are not subject to double taxation. Unfortunately, a corporation is subject to this double taxation. For example, if the company makes X amount of dollars, the corporation is taxed on these dollars. In addition to be taxed on that money, any distributions the corporation makes to shareholders is also taxed. Therefore, the same dollar is getting taxed twice.

Last, it is easier to raise capital because you can sell interests in these entities. Whether in the form of stock or units, these entities have a more effective way of raising capital as compare to the unlimited liability companies.

These positives also have some negatives. First, management is not as easy. Most of these entities have various levels of managements (including board of directors and officers) and have to accomplish various formalities (such as annual meetings, recording minutes, and elections by shareholders). These management levels and formalities can slow down progress and may cause conflicts between managers with differing points of views and interests.

Second, many filing fees exist. In addition to having to file a certificate of registration (for a limited partnership), articles of organization (for a limited liability company), or articles of incorporation (for a corporation), you have to file certain papers designating a resident agent and provide annual lists. Additionally, some states may not allow some of these entities to be formed (specifically a limited liability company and a limited liability limited partnership), therefore, you need to check you local laws. All of these requirements can cost hundred, if not thousands of dollars, to file.

Last, there can be conflicting interests (between shareholders, managers, and officers) as to who gets what money. These competing interests can lead to voting issues and well as possible lawsuits. Both of these will cost time and money.

Like with the pervious post, you need to consult an attorney before you try to form any of these entities by yourself. This post is intended to give you a brief overview of some limited liability companies so that you know of some options that exist for your present or future business.

The Types of Business Organizations

Business entities can be distinguished into two different categories: (1) unlimited liability entities; and (2) limited liability entities. In order for you to have a better understanding of these various entities, this post will be broken into two parts. This part will discuss unlimited liability entities.

Unlimited liability entities mean that in the even that you get sued, a claimant has the possibility of recovering against all of your assets. You are not personally protected if you form an unlimited liability entity.

Two types of unlimited liability business entities exist: (1) a sole proprietorship; and (2) a general partnership. You may be wondering why somebody would set up one of these entities. If you can be held personally liable for all judgments against your business, what is the advantage of forming one of these? Although a person may be held personally liable, there are some advantages to setting up one of these entities.

First, no filing requirements exist with either of these entities. This is great because you literally save hundreds, if not thousands, of dollars. States require a filing fee and the execution of certain documents for other entities, however, these two unlimited liability entities require neither.

Second, both of these entities are very easy to operate. There are no board of directors, no stock holders, and no other level of management except you. This creates a very easy management situation because you only have you to answer to.

Last, these entities do not have the problem of double taxation. In other words, any money the company makes is not taxed separately from the money is distributes. The money saving tax advantage to this is obvious.

Unfortunately, some negatives exist in forming these types of entities. First, and most obviously, you are unlimitedly liable for all debts and judgments. This can literally financially ruin you.

Second, raising capital can be difficult. You cannot sell shares of stock because there are no shares. Usually, you bring all of the money to the table or you have to take on a partner in order to receive capital.

Last, you cannot transfer your interest in these entities. In other words, you cannot sell your ownership in these companies. The effect of selling your interest is the dissolution of the previously existing entity. For example, if you owned a corporation, you could sell your stock to whomever you want (and thus in effect, sell your ownership interest in that company) without creating a dissolution. The same is not true with these unlimited liability entities.

The previous was just a brief overview of some of the various entities you can form. Do not dive head first into forming a company. Although they offer various business and tax advantages, you will probably want to talk with a lawyer before forming anything.