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A California Corporation Provides Asset Protection, But It Can Be Lost - Piercing the Corporate Veil

 
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A California Corporation Provides Asset Protection, But It Can Be Lost - Piercing the Corporate Veil

Prepared By: Melissa C. Marsh, Los Angeles Business Attorney
Written: March 2009
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How A Corporation Provides Asset Protection.

A California corporation can protect (shield) the owners personal assets from the corporate debts, liabilities and obligations. Shielding personal assets from corporate liabilities (Asset Protection) is generally one of the primary purposes of incorporation. However, many business owners who have incorporated their business do not realize that the law allows creditors, and other claimants, to "pierce the corporate veil" of improperly maintained corporations. If a creditor pierces the corporate veil, the creditor can go after the owner's personal assets (home, bank account, investments, and other assets) to satisfy corporate debt, obligations and liabilities. The theory behind this legal concept is that shareholders who blur the distinction between the corporation and themselves should not be allowed to hide behind the corporate veil. To preserve your personal liability protection, to protect your personal assets, your corporation must be considered an entity unto itself, separate and distinct from its shareholders (owners)—you!

How Shareholders of a California Corporation Lose that Asset Protection - Piercing The Corporate Veil.
To "pierce the corporate veil" of a California corporation, a court must find: (1) "unity of interest and ownership" between the corporation and the shareholders such that the identity of the corporation and the individual shareholders are no longer separate; and (2) that to preserve the corporate identity and allow its owners to dodge personal liability would cause an "inequitable result". The key to protecting the personal liability protection afforded by the corporation to its shareholders is for the shareholders to treat the corporation as a separate and distinct entity by carefully maintaining the corporation's separateness through issuance of stock, adequate capitalization, observation of the corporate formalities, proper maintenance of the corporate minute book, and proper maintenance of financial records. These actions will help prevent a potential plaintiff or litigant from proving "unity of interest and ownership" between the corporation and its shareholders (owners).

Asset Protection Will Be Lost If A Court Finds Unity Of Interest.
To prove "unity of interest and ownership" and in turn expose the owners (shareholders) personal assets to possible attachment by a creditor of a California corporation generally requires a court to find that the shareholders failed to respect corporate separateness by one or more of the following:

  1. Failing To Issue Stock.
    Failure to issue stock is a failure to perform one of the basic requirements of a corporation.

  2. Failing To Adequately Capitalize The Corporation.
    If the corporation has never been funded, there is no financial basis for the corporation to be a separate entity. In addition, the corporation must be funded with sufficient funds relative to the size and nature of the business to ensure the corporation is financially viable. The amount of initial money or property that constitutes adequate capitalization is anybody's guess but courts generally: (1) compare the amount of money contributed to the nature and magnitude of the corporate undertaking and (2) look at the owner's intent. In other words, was the company set up with the idea of defrauding its creditors? How long after the owner contributed capital to the company did the owner contract liability on behalf of the Company? Was the liability reasonable or grossly disproportionate to the amount of capital contributed? One thing is for sure, capitalizing a corporation with just $500 is probably inadequate.

  3. Commingling Corporate and Personal Assets or Funds.
    Failing to keep corporate and personal assets separate and distinct, exposes the corporation to the charge that there is "unity of interest" such that the corporate bank account is really just a personal asset of the individual shareholder(s). It is essential to keep your personal assets and funds separate and apart for those belonging to the corporation. Do not pay personal bills and expenses with a corporate check or credit card. Do not pay business related expenses with a personal check or credit card. Do not use the same office or business location for the corporate business and some other business. If you need to make a loan to the corporation, make sure it is documented by a promissory note and special minutes approving of the term of the loan and the promissory note.

  4. Failing To Keep Separate Corporate Financial Records.
    If the separate status of the corporation cannot be established through normal accounting records and financial statements, shareholders will be held personally liable. It is very important to notice, hold and document director and shareholder approvals of significant corporate activities including borrowing, compensation and purchase decisions. When a corporation has a single shareholder and/or director it is ultra important to follow this particular rule and to notice, hold, and document the corporate meetings.

  5. Domination and Control of the Corporation By One Shareholder or a Few Key Individuals.
    This issue alone will not lead to a piercing of the corporate veil, but often will if coupled with one or more of the other factors like failing to maintain corporate records and minutes. Many small businesses are dominated by one shareholder, and it is especially important for such businesses to keep up all other formal aspects of maintaining a separate corporation. Under California law, a claim that one shareholder dominates the corporation or that the corporation is the "alter ego" of the shareholder is just another way of saying that there is a "unity of interest" between the corporation and the shareholder. A sole shareholder must therefore be extremely more cautious about respecting the separate identity of the corporation. The following points should be of particular concern to a sole shareholder.

  6. Failing To Notice, Hold and Document Meetings Of The Shareholders and Directors.
    Holding regular meetings of the shareholders and directors is a primary means of preserving the separate identity of the corporation. Failing to notice, hold, and properly document the meetings of the director(s) and shareholder(s), creates a basis for "unity of interest." State statutes require corporations to notice, hold and properly document, at the very least, an annual meeting of the shareholder(s) to elect the board of directors and to approve of fundamental changes such as a consolidation or merger.

  7. Failing to maintain corporate records and minutes.
    While it may sound extreme, I regularly see corporate minute books devoid of minutes.

Asset Protection Will Also Be Lost if a Court Finds Fraud – Forming The Corporation to Avoid An Obligation or to Perpetrate a Fraud.

Another way to pierce the corporation veil is to prove "fraud." The courts will disregard the corporate entity when it is necessary to prevent fraud or to prevent an individual shareholder from using the corporate entity to avoid his existing personal obligations. In other words, a shareholder can't set up a corporation without a valid business purpose. Shareholders should not siphon funds in an effort to "judgment proof" the corporation. Shareholders should be careful to not mislead third parties into thinking that shareholders will perform the corporation's obligations or that the corporation has assets that are really personally owned by the shareholders. If the corporation becomes insolvent or in financial distress, don’t incur additional debts or liabilities.

Don't Lose the Personal Limited Liability Protection offered by a California Corporation.

Each of the above-mentioned factors may be used to pierce the corporate veil and hold the shareholders of a corporation personally liable for what may be legitimate corporate debts and responsibilities. Take your ownership responsibilities seriously and treat your corporation as a separate and distinct entity. Use a bookkeeper to keep track of your corporation's income and expenses. Comply with all of the governmental reporting requirements in a timely fashion. Notice, hold, and properly document your annual meetings of the shareholders and directors, and hold special meetings to approve a loan, acquisition of a line of credit, establishment of a credit card account, lease or lease renewal, and any unusually large or uncommon transactions. Most importantly, seek legal counsel if you are confused or unsure about whether you are in compliance with any of the elements discussed above!

If you would like to have a Los Angeles, California business law attorney with 15+ years of experience audit your California corporation to determine what needs to be done to restore the corporation's separate legal entity status, call 818-849-5206 or E-mail Your Request .


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Disclaimer: The information presented on this web site was prepared by Melissa C. Marsh for general informational purposes only and does not constitute legal advice. The information provided in my articles and alerts should not be relied upon, or used as a substitute for professional legal advice from an attorney you retain to advise or represent you. Your use of this Internet site does not create an attorney- client relationship. Transmission of this article is not intended to create, and receipt of it does not constitute, an attorney-client relationship. All uses of the contents of this site, other than personal uses, are prohibited. You may print or email a copy of any information posted on this web site for your own personal, non-commercial, use, but you may not publish any of the articles or posts on this web site without the Express Written Permission of Melissa C. Marsh.


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Located in Los Angeles, California, the Law Office of Melissa C. Marsh handles business law and corporation law matters as a lawyer for clients throughout Los Angeles including Burbank, Sherman Oaks, Studio City, Valley Village, North Hollywood, Woodland Hills, Hollywood, West LA as well as Riverside County, San Fernando, Ventura County, and Santa Clarita. Attorney Melissa C. Marsh has considerable experience handling business matters both nationally and internationally. We routinely assist our clients with incorporation, forming a California corporation, forming a California llc, partnership, annual minutes, shareholder meetings, director meetings, getting a taxpayer ID number (EIN), buying a business, selling a business, commercial lease review, employee disputes, independent contractors, construction, and personal matters such as preparing a will, living trust, power of attorney, health care directive, and more.