Limited liability means you are not responsible for a business’s debts, and generally the business is not responsible for your personal debts. It is like you and your business are two unrelated people–almost like your business is a distinct person. Unless a creditor convinces a judge that it is your alter ego, it will remain separate.
This talk is about liability of management. Even though managers, corporate officers, directors, and managing partners are not liable for business debts, they may be held liable for their own torturous acts, even if done while working on behalf of the company. Hence the existence of directors and officers insurance.
Alter ego arguments are arguments creditors will use to try to get after your business assets and not all of these apply to entities that are not corporations. The first is called ‘instrumentality’or ‘domination’and this is where a single person manages an entire entity thus ignoring the multitiered management structure the entity is supposedly have. This currently only applies to corporations which should have a Board of Directors and corporate officers. A single person for filling all the rules in a Corporation may cause the Corporation to be held as that person’s alter ego. This alter ego argument is not applied equally amongst the 50 states! It varies from state to state.
A lot of one man S corporations can find themselves in hot water if they are sued and the plaintiff argues along these lines. It is better to use an LLC taxed as an S Corporation. It is okay to dominate an LLC with a single manager.
The next argument is called ‘improper purpose’and is when you use the entity to perpetrate fraud or injustice or when you are a business entity for personal use. Co-mingling business and personal funds or using business funds for personal use is also considered an improper purpose. If an entity is created with no business purpose and personal assets transferred to them with no relationship to any business purpose simply as a means of shielding them from creditors, under such circumstances, the law views the entity is the alter ego of the individual debtor and will disregard it to prevent injustice.
The next topic is the argument related to ‘proximate cause’ which means that the lawsuit would that must be tied to the business entities activity. If it is not then a creditor cannot sue or argue alter ego for the entity unless there is suing an owner of the entity and are trying to reverse pierce it. But just because you do not own, but are still tied to it in a stealthy manner, and entity does not mean you cannot be tied to it. This is why bearer shares often do not work and may cause other problems.
If the company does not have enough capital to meet its anticipated debts, then it can be pierced under the theory of under capitalization. Creditors believe your corporation should have enough cash to pay for all the inventory you just ordered, and a judge may pierce the entity if you do not.
Reverse piercing is when a creditor tries to get assets in a business for the debt of one of its owners. We discussed this in the lesson on charging order protection. Normal piercing is when a creditor tries to get an entity owner’s personal assets for debt or judgment against the business.