Liability of a Corporation’s Individual Members

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 What Is a Corporation?

A corporation is a specific type of business structure, created and regulated by state law. More specifically, a corporation can be defined as a legal entity that is separate from its owners, or, its shareholders. What this means is that only the corporation itself can be held liable for corporate obligations. An example of this would be maintaining certain business records.

Generally speaking, a corporation is classified according to specific factors, such as:

  • Their tax structure;
  • The general purpose of the corporation; and
  • The number of shareholders involved, as well as the amount of stock to be issued.

Some common examples of forms of corporations include:

  • C Corporation;
  • S Corporation;
  • Non-Profit Corporation;
  • Business Corporation;
  • Professional Corporation;
  • Foreign Corporation; and
  • Public or Private Corporation.

However, the term corporation generally refers to the two main categories that corporations are divided into according to tax laws, which would be C Corporations and S Corporations. The defining difference between these two types of corporations is that C Corporations are taxed separately from their owners, while S Corporations are not.

Some other benefits to forming a corporation include:

  • They can survive changes in ownership, which means that in theory, they can exist forever;
  • They are considered to be “people,” which means that they are entitled to certain constitutional protections; and
  • As only the corporation itself can be held responsible for its obligations, they have limited liability.

How Is Liability Of a Corporation’s Individual Members Determined?

Limited liability of members in a corporation was created in order to encourage investors to fund the operations of a business, while also providing shareholders with the ability to invest without fear of being held liable for the debts and obligations of the company.

One of the main reasons why many people form a corporation or limited liability company (“LLC”) is because they do not want to be held personally liable for any business debts that they incur. However, if an owner, director, or majority shareholder uses that corporation as a shield for personal debt, courts will hold the owners and shareholder personally liable by “piercing the corporate veil.” This will be further discussed below.

To reiterate, a corporation is liable for its obligations. Because of this, creditors may only rely on the corporation and its business assets to receive payments. Individual shareholders are generally shielded from being held personally liable for business losses, so long as the corporation was properly established and is run appropriately. As such, the only risk the shareholders face are any investments that they themselves have made in the corporation.

However, there are specific circumstances in which limited liability will not protect an owner’s personal assets, meaning they can be held personally liable. This could happen when an owner:

  • Personally and directly causes injury to another person;
  • Fails to deposit taxes withheld from wages of the corporation’s employees;
  • Engages in any activity that is intentionally fraudulent or illegal, and that causes harm to the company or someone else;
  • Personally secures or guarantees a bank loan or a business debt on which the corporation defaults; and/or
  • Treats the corporation as an extension of their personal business affairs, rather than as a separate legal entity.

There are also some circumstances in which a court can rule that a corporation does not exist, and that its owners are actually doing business as individuals. The individual owners may be held personally liable for any business obligations that arise. This happens most often when there is a failure to follow corporate formalities, such as failing to:

  • Adequately invest in the corporation;
  • Formally issue stock to the initial shareholders;
  • Regularly hold meetings of directors and shareholders; and
  • Keep business records and transactions separate from those of the owners.

What Is Piercing The Corporate Veil? How Is The Corporate Veil Pierced?

Because of limited liability, the corporation acts as a shield to protect individual shareholders from claimants and creditors who are seeking to satisfy a judgment against the corporation. However, limited liability is not absolute; what this means is that the limited liability of shareholders in a corporation may be disregarded. This is often referred to as “piercing the corporate veil.”

Piercing the corporate veil would occur if the owners, officers, directors, or shareholders do not have a real separation between the corporation and their personal obligations. It would also occur if those parties use the corporation’s limited liability advantage to their own personal advantage.

Should the court determine that the owners, directors, or shareholders are abusing the corporate status and shielding their personal liability with the corporate liability, the court will pierce the corporate veil in order to hold the owners, directors, or shareholders personally liable. What this means is that creditors that are owed debt can go after the owner’s, directors, and shareholders personal property in order to satisfy the debt.

Some of the factors that courts consider when determining whether to pierce the corporate veil include:

  1. Alter Ego: The owners or directors failed to maintain a separation between the corporation and their own personal financial affairs. This would be considered if the court determines that the owners and directors only used the corporation as an imitation or sham, simply to enjoy the limited liability status and treat the corporate status as their own;
  2. Inadequate Capitalization: If at the time of the formation of the corporation, there was insufficient capitalization that would generally be sufficient to cover prospective liabilities, this would be taken into consideration;
  3. Wrongful or Fraudulent Conduct: If the owners and directors used fraudulently borrowed corporate assets, or entered into transactions dishonestly or to avoid personal liability with no intent to repay the future debt, then the limited liability would not apply. As such, the violators will be personally liable for the transactions and debts that were incurred; and/or
  4. Failure of Corporate Formalities: If the owners and shareholders failed to comply with corporate formalities, it is possible that there was no real intent to form a valid corporation. This may indicate that the corporation was made fraudulently, in order to enjoy the limited liability status.

What Other Factors Will Be Considered?

It is important to note that the factors for determining whether there is a unity of interest and ownership, and whether the separateness has been blurred, can vary depending on state laws. Generally speaking, the following factors will be taken into consideration:

  • The nature of the corporation ownership and control;
  • The creation and maintenance of corporate minutes and records;
  • Compliance with various corporate formalities such as electing directors, issuing shares, and acting through votes and resolutions;
  • Commingling of the funds of shareholders and the corporation;
  • The use of corporate funds for personal uses of shareholders;
  • Maintenance of separate offices and facilities; and
  • Failure to comply with corporate formalities.

Do I Need An Attorney For Issues Associated With Liability Of a Corporation’s Individual Members?

It is important to remember that courts will generally not pierce the corporate veil unless the shareholder clearly used the limited liability protection provided by the corporation to engage in wrongful actions.

If you would like to bring a legal action against a corporation, or if you have any questions regarding liability of a corporation’s individual members, you should contact an experienced and local corporate lawyer. An attorney can help you understand your rights and obligations under your state’s specific corporation laws, and will also be able to represent you in court, as needed.

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