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.