When formed and used correctly, corporate entities can be tremendous tools for limiting personal exposure to liability and protecting your individual assets. As such, an entity, must be treated as a separate legal entity, separate and apart from its owners. These so-called “corporate formalities” must be observed by an entity. Privileges, such as limited liability of the owners may be lost if certain formalities are not followed. This is of a particular significance in the case of the one-person, family, or other closely-held entity because disregarding the entity as a separate legal “person” may arise when an owner attempts to enter into a contract for the entity without first observing the necessary corporate formalities. The general rule is that a corporation’s shareholders, owners, and directors are not personally liable for the entity’s contracts, debts, or torts. But just because it walks like a corporation and talks like a corporation, that doesn’t necessarily mean that a court will treat it like a corporation. When the corporate privilege is abused—when the entity is used for an improper purpose or certain rules and regulations regarding corporate formalities are not followed—the shareholders, owners, and directors may lose their protection and be held personally liable for the corporations obligations, a phenomenon commonly called “piercing the corporate veil.” In order to prevent this occurrence from happening to you, it is important to know what circumstances and events may cause a court to “pierce the corporate veil” of your entity.
Texas courts recognize three broad categories of circumstances under which the corporate veil might be pierced: (1) when the corporation is an alter ego of the individual or another parent corporation; (2) when the corporation is a sham to perpetuate a fraud; and (3) when the corporation is used for an illegal purpose. The first of these categories, the alter ego doctrine, is the category most commonly cited when attempting to pierce the corporate veil.
Under the alter ego doctrine, a corporate entity may be disregarded (the corporate veil may be pierced) when there is such unity between the corporation and the individual that separateness between the two no longer exists and holding only the corporation liable would result in injustice. In deciding whether unity exists, which would justify piercing the veil, a court will look at whole picture, or the entire dealings between the corporation and the individual. Specifically, a court may look at whether corporate debts were paid with personal checks or whether corporate and individual funds were otherwise commingled, whether it was represented that the individual would financially back the corporation, whether company profits were diverted to the individual for personal use, whether the corporation was adequately capitalized, and whether there was a failure to keep the corporate assets and personal assets separate. While the failure of an entity to observe certain corporate formalities was previously an important factor in deciding whether the alter ego doctrine could be applied, a Texas statute has since made this factor irrelevant. Additionally, while potentially relevant, proof that a single person owns all the shares in an entity is not sufficient for a court to find that the company and the individual are essentially one and the same, and that the entity should be disregarded. Courts require something more than simply a unity of financial interest, ownership, or control to apply this doctrine.
The second category under which the corporate veil may be pierced is the category of a “sham to perpetuate a fraud.” Under this category, when the corporation is used to evade an existing legal obligation or to perpetuate a fraud, then the corporate veil may be pierced and the owners and shareholders may be held liable for corporate acts. To determine whether a corporate entity may be disregarded under this category, courts may ask whether honoring the legal independence of the entity would result in injustice or inequity to the person bringing the claim. In this case, the focus is on the unfairness to the person bringing the claim that was caused by the corporation and its owners, and thus the focus is on the relationship between the corporation and the claimant. For example, a classic instance of sham to perpetuate fraud is when a closely held corporation has unwanted debts and obligations, and so it siphons off corporate revenues, sells many of its assets, and does other acts which hinder its business and limits its ability to pay off debts.
The final broad category is use for an illegal purpose, and is generally only used as an alternative to the first two categories. This category is similar to alter ego, in that courts generally focus on the relationship between the corporation, the owners, and the laws of the state, and not on the relationship between the corporation and the person bringing the claim, as is the case under the category of sham to perpetuate a fraud. However, this category differs from the alter ego category in that it can be used even when all corporate formalities have been followed, and the entity and the individual have been largely kept legally separate.
It is also important to note that courts treat cases involving obligations under a contract and cases involving tort liability very differently. In general, there are six circumstances under which a court will pierce the corporate veil: (1) when the corporate form is used as a means to perpetuate fraud; (2) when the corporation is organized as a tool or business conduit of another; (3) where the corporate form is used as a means of evading an existing legal obligation; (4) when the corporate form is used to achieve or promote a monopoly; (5) when the corporate form is used to circumvent a statute; and (6) when the corporate form is relied on to protect a crime or justify a wrong. These six circumstances overlap and intermingle with the three broader categories described above. Cases dealing with contractual obligations, on the other hand, are governed by statute in Texas. Under Texas law, to pierce to corporate veil and hold a shareholder or owner of a corporation personally liable for a contractual obligation, the person bringing the claim must prove (1) that the shareholder caused the corporation to be used for the purpose of perpetuating, and did perpetuate, an actual fraud on the claimant, and (2) that the fraud was perpetrated for the direct personal benefit of the shareholder. Without such a showing, the corporate veil may not be pierced in contract cases under any theory.
In disregarding a corporate entity, or piercing the corporate veil, Texas courts take a flexible, fact-based approach, and generally will not pierce the corporate veil under any theory or situation absent exceptional circumstances. Still, it is important to be aware of what circumstances might lead a court to disregard your corporate entity and hold you personally liable, so that you can take care to avoid this unhappy result.
For more information on corporate entities and piercing the corporate veil, please schedule a consult at firstname.lastname@example.org. Thank you for the significant contribution by SMU law student, Erin Brewer, for the research and drafting of this article.