Mixing (Small) Business With Pleasure: The Alter Ego Doctrine

Posted on: October 18th, 2014

One of the most important reasons for selecting a corporation or limited liability company (LLC) as a business entity is personal asset protection for the small business owner. Unlike a sole proprietor who has unlimited personal liability for the obligations of his/her business, the law sees corporations and its shareholders as separate legal entities. One of the advantages of this distinction is that corporate shareholders and LLC members are shielded from personal liability from their companies’ debt. However, this shield can be defeated in cases where fraud or bad faith are present and the corporation is deemed to be a mere alter ego of its shareholders. The alter ego doctrine provides that the corporate veil may be pierced when:

1. There is a unity of interest between the corporation and its owners that the separate personalities of each do not really exist, and
2. It would promote an injustice to uphold the corporate entity and permit the shareholders/members to escape personal liability.

There are a number of factors that the court can weigh in determining whether to pierce the corporate veil. In California, they include some of the following:

1. Corporate funds and property are commingled with the small business owners personal assets;
2. Corporate funds are used to pay for business owner’s personal bills (i.e., mortgage or credit cards);
3. Corporation did not maintain proper corporate records;
4. Failing to abide by corporate formalities;
5. Inadequate capitalization;

If a court finds that the corporate veil should be pierced, the LLC members and corporate shareholders are held jointly and severally liable for its debts. It is important that small business owners understand the importance of keeping their personal affairs and those of the corporation/LLC separate.