Running a business is like navigating a minefield on a unicycle. To limit risk, entrepreneurs incorporate. There are other reasons to incorporate (e.g., documenting a structure with a partner), but covering the downside is the main reason for forming a corporation. Courts have acknowledged that the law "permits the incorporation of a business for the very purpose of enabling its proprietors to escape personal liability."
But not so fast - that protection can be lost if the entrepreneur fails to treat the corporation like it's a real corporation. That's right -- even if you incorporate, the liability protection might not be there when you need it. This is referred to as "alter ego liability" or "piercing the corporate veil". Magazine articles, radio ads, and seminars would have you think that "piercing the corporate veil" is some sort of mysterious event that takes everyone by surprise when it happens, but that's not the case at all. Nearly 50 years ago, the California Supreme Court in a case called Associated Vendors v. Oakland Meat created a test that paints a very clear picture of how to prevent alter ego liability.
The Associated Vendors "test" is a secret recipe for liability protection. It's a list of a couple of dozen factors. No one factor matters more than the others, but if taken as a whole it seems that the corporate form was not respected, the shareholder will be held liable. Some of the factors include whether the corporation was adequately capitalized, whether corporate assets were used by the shareholder for personal use, and whether there was commingling of corporate and personal funds.
In the day-to-day insanity of running a small business, it's frequently hard to avoid some of these factors. Who hasn't needed to pull some money out of their business bank account to fix a leaky roof or pay their kid's summer camp bill? The good news is that Courts don't require perfection. They just look at the facts and circumstances to determine whether on balance, it seems like the corporate form has been respected.
That's why it blows my mind when I see small corporations fail to nail the easy ones on the list. Remarkably, one of the most important factors is also incredibly easy for a small corporation to satisfy - keeping corporate minutes. Whether a corporation keeps corporate minutes is a factor that comes up in virtually every alter ego case. Even in the Associated Vendors case itself, the court refused to pierce the corporate veil even though the corporation was undercapitalized, because the corporation held "a number of meetings" and kept minutes.
In a case involving a lawsuit on a lease, a one-person corporation's inadequate capitalization was not sufficient to establish alter ego liability where the corporation conducted annual board meetings and "memorialized the meetings in the corporate minutes." Despite being the sole director, the individual even went so far as to call special sessions of the board to authorize important corporate decisions, such as the purchase of an office building, and those sessions "were also memorialized in the corporate minutes."
On the other hand, in virtually every case where the corporate veil was pierced, failing to keep minutes has been a common theme. In one case, the shareholders were personally liable for more than $4.5 million in damages. The Court noted that the shareholders "elected not to memorialize [even] the most significant events in the history of the" corporation in the minutes.
If you are sued as the "alter ego" of your corporation, you will have to produce a copy of your corporate minute book. One Court noted (rather obviously) that "it is simply not enough to have a minute book if no minutes are kept in that book," but far too many small corporations have a dusty, faux-leather corporate minute book without any minutes kept in the book. In one case involving a DJ, the shareholder was held liable for $77,000 where he could not produce a "single slip of paper" showing that he held formal meetings or kept corporate minutes. Being able to respond with copies of properly maintained minutes - a very simple task for a corporation that regularly holds meetings and keeps minutes - is the best way to prevent alter ego liability.
For nearly five decades, dozens of cases in every major jurisdiction have involved corporate minutes. Sure there are other reasons that the corporate veil is pierced, but the courts are plainly telling us that "memorializing meetings in corporate minutes" is one of the key ingredients of asset protection.
But not so fast - that protection can be lost if the entrepreneur fails to treat the corporation like it's a real corporation. That's right -- even if you incorporate, the liability protection might not be there when you need it. This is referred to as "alter ego liability" or "piercing the corporate veil". Magazine articles, radio ads, and seminars would have you think that "piercing the corporate veil" is some sort of mysterious event that takes everyone by surprise when it happens, but that's not the case at all. Nearly 50 years ago, the California Supreme Court in a case called Associated Vendors v. Oakland Meat created a test that paints a very clear picture of how to prevent alter ego liability.
The Associated Vendors "test" is a secret recipe for liability protection. It's a list of a couple of dozen factors. No one factor matters more than the others, but if taken as a whole it seems that the corporate form was not respected, the shareholder will be held liable. Some of the factors include whether the corporation was adequately capitalized, whether corporate assets were used by the shareholder for personal use, and whether there was commingling of corporate and personal funds.
In the day-to-day insanity of running a small business, it's frequently hard to avoid some of these factors. Who hasn't needed to pull some money out of their business bank account to fix a leaky roof or pay their kid's summer camp bill? The good news is that Courts don't require perfection. They just look at the facts and circumstances to determine whether on balance, it seems like the corporate form has been respected.
That's why it blows my mind when I see small corporations fail to nail the easy ones on the list. Remarkably, one of the most important factors is also incredibly easy for a small corporation to satisfy - keeping corporate minutes. Whether a corporation keeps corporate minutes is a factor that comes up in virtually every alter ego case. Even in the Associated Vendors case itself, the court refused to pierce the corporate veil even though the corporation was undercapitalized, because the corporation held "a number of meetings" and kept minutes.
In a case involving a lawsuit on a lease, a one-person corporation's inadequate capitalization was not sufficient to establish alter ego liability where the corporation conducted annual board meetings and "memorialized the meetings in the corporate minutes." Despite being the sole director, the individual even went so far as to call special sessions of the board to authorize important corporate decisions, such as the purchase of an office building, and those sessions "were also memorialized in the corporate minutes."
On the other hand, in virtually every case where the corporate veil was pierced, failing to keep minutes has been a common theme. In one case, the shareholders were personally liable for more than $4.5 million in damages. The Court noted that the shareholders "elected not to memorialize [even] the most significant events in the history of the" corporation in the minutes.
If you are sued as the "alter ego" of your corporation, you will have to produce a copy of your corporate minute book. One Court noted (rather obviously) that "it is simply not enough to have a minute book if no minutes are kept in that book," but far too many small corporations have a dusty, faux-leather corporate minute book without any minutes kept in the book. In one case involving a DJ, the shareholder was held liable for $77,000 where he could not produce a "single slip of paper" showing that he held formal meetings or kept corporate minutes. Being able to respond with copies of properly maintained minutes - a very simple task for a corporation that regularly holds meetings and keeps minutes - is the best way to prevent alter ego liability.
For nearly five decades, dozens of cases in every major jurisdiction have involved corporate minutes. Sure there are other reasons that the corporate veil is pierced, but the courts are plainly telling us that "memorializing meetings in corporate minutes" is one of the key ingredients of asset protection.
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