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Piercing the Veil: A Personal Liability Nightmare
By Richard A. Chapo, Esq.

Business owners that use limited liability companies or corporations are often surprised to learn that they run the potential risk of being personally liable for the debts of the business. Personal liability can arise when the business owners fail to treat the business entity as an independent structure, instead mixing their personal finances and affairs in those of the business. The legal theory for invalidating the protection normally created by using a business entity is known as "piercing the veil."

A claim by a plaintiff to pierce the corporate veil is one where it is asserted that the business entity should be disregarded because of the acts of the business owners. In short, the plaintiff is attempting to argue that the corporation is a sham or front for the personal dealings of the business owners.

California Law

Corporate law in the State of California is fairly clear on the issue of when a business entity will not protect the business owners from liability. There are specific issues that are focused on:

whether there is such a "unity of ownership and interest" between the business owners and the corporation that the business can be considered the "alter ego" of the shareholders; or
whether the business has failed to follow corporate formalities in areas such as record-keeping and decision-making procedures.

Real World Examples

"it would be unjust to permit those who control companies to treat them as a single or a unitary enterprise and then assert their . . . separateness in order to commit misdeeds with impunity." Los Palmas Associates v. Los Palmas Center Associates

The term "incorporate" means to create a legal body. The principal advantage to incorporating is to limit a shareholder's potential loss to the amount invested in the entity. Unfortunately, entities that do not follow proper corporate procedures often fail to gain this protection.

In DeWitt Truck Brokers, Inc. v. W. Ray Flemming Fruit Co., the court ruled in favor of piercing the corporate veil of the Flemming Fruit Company when it determined that the primary shareholder of the defendant had:

Siphoned down the original risk capital that was used to fund the corporation;
Took excessive salary versus paying the debts of the corporation;
Personally used credit extensions made to the corporation,
Made oral statements that he would be personally liable for the outstanding credit, and
Failed to pass corporate resolutions regarding debt obligations.

As a result of the ruling, Mr. Flemming was forced to personally satisfy all the debts of the business entity.

In Sea-Land Services, Inc., v. Pepper Source, the court found in favor of piercing the corporate veil and applying personal liability in the amount of $87,000 to the sole shareholder of Pepper Source because he had:

Borrowed large sums of money from Pepper Source interest free;
Used the corporation's bank accounts to pay personal expenses including alimony and child support; and
Failed to provide any monetary capitalization when setting up the corporation.

Once again, the shareholder was forced to personally satisfy the debts.

As you can see, there are additional steps above and beyond getting a corporate filing $199 from a service. The failure to properly setup and maintain your business entity can have harsh results when you really need the asset protection element of the business. Remember the famous cliché, "You Get What You Pay For…"

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Richard Chapo is the lead attorney for SanDiegoIncorporate.com, based in San Diego, California. He can be contacted at Richard@sandiegoincorporate.com. or 619-992-1867. This article is for general education purposes and does not address every facet of the laws surrounding the subject. Nothing in this article creates an attorney-client relationship.