Many clients who have established a business as a corporation, or even better, as a limited liability company are worried that their creditors who obtain a judgment will be able to pierce the corporation and attack their personal assets. This creditor tactic is referred to as piercing the corporate veil.
One of the most important functions of a company, whether it is a corporation or LLC, is its limited liability shield. The limited liability shield prevents the liability of the company from extending to its owners.
In other words, if your company is found liable for a debt, then that liability will not also be shared by you as the individual shareholder. This limited liability encourages an individual to take on risk in starting a company—otherwise potential business owners would subject themselves to considerable financial risk when forming an LLC or corporation.
A creditor who successfully pierces the corporate veil makes the individual liable for the company’s debt despite the traditional liability shield.
Piercing the Corporate Veil Is Difficult
Under Florida law it is very difficult to pierce a corporation so long as the corporation operated as a distinct and separate entity.
In Dania Jai-Alai Palace, Inc. v. Sykes, the Florida Supreme Court established the standard to be applied in a piercing the corporate veil claim. Under the Court’s ruling, in order to pierce the corporate veil in Florida, a plaintiff must prove two separate elements.
First, the corporation must be a mere instrumentality or alter ego of the defendant.
Second, the defendant must have engaged in “improper conduct.”
The Court reasoned that the corporate veil should not be pierced unless it is shown that the corporation was organized or employed to mislead creditors or to work a fraud on them.
The first prong of the two-part test requires a creditor to prove that the business is an alter-ego of the debtor. One court explained that the creditor must show that the “shareholder dominated and controlled the corporation to such an extent that the corporation’s independent existence, was in fact non-existent and the shareholders were in fact alter egos of the corporation.”
The most prevalent reason for a corporation (or an LLC) not protecting people’s personal assets is that they operate the corporation as their “alter-ego” which means, most simply, that they pay personal expenses out of the corporation and withdraw money from the corporation as needed.
The proper practice is for your corporation to pay the owner and other employees a periodic salary and dividends (or in the case of an LLC, member distributions).
Courts usually look at a list of factors that could show that the company is an alter-ego of the individual. These piercing the corporate veil factors include, for example:
- Failure to follow corporate formalities. But note: just because the business owner does not update corporate records and minutes each year in a timely manner is not sufficient to pierce the corporation.
- Inadequate capitalization. In other words, not funding the company with enough money or assets.
- Comingling of assets. For example, putting all of your personal money in the company’s account, or vice-versa.
We suggest maintaining a separate corporate bank account and that you do not commingle personal money unless clearly documented as loans. In short, respect the separate existence of your business and do not treat the business checking account as your personal savings account or piggy bank. If you follow these simple guidelines, a creditor is unlikely to defeat corporate asset protection under Florida law.
The second prong under the two-part test for piercing the corporate veil is to show that the company was formed for an improper or fraudulent purposes. In other words, even if your company is a complete alter-ego of the shareholder, a creditor will still in almost all circumstances be unable to pierce the corporate veil unless the company was formed for an improper purpose.
This test is difficult to satisfy.
For example, improper purpose would mean the that company was formed to commit a fraud, that the purpose of the company was to evade the law or evade responsibility for a debt, or the that the company was formed to mislead creditors. Note that all of these examples reference the formation or organization of the company.
Reverse piercing is a lesser known, and lesser used, concept where a creditor of an individual can execute on corporate assets to satisfy a civil judgment against the individual owners. A creditor can use the reverse-pierce remedy to hold a corporation liable for the debts of the controlling shareholder where the shareholder/debtor formed or used the corporation to secret assets and avoid preexisting personal liability.
For example, if an individual facing a possible individual judgment creates a corporation or LLC and transfers assets in to a controlled entity so the assets would be protected from a civil judgment then individual’s creditors could levy upon the corporate assets under the reverse-piercing theory.
Reverse-piercing is similar to fraudulent conveyance; both legal concepts are equitable remedies to execute a civil judgment. A creditor can sue a corporation that received the owner’s personal assets to help the owner evade personal liability under either theory. If you want to know more about reverse-piercing of a corporation, look at Braswell v. Ryan Investments, 389 So. 2d 38.