A Corporation has a veil of protection around its owners or shareholders to protect the shareholders from personal liability. However, the protection is not absolute. There are different scenarios in which a court can “pierce the corporate veil” and find that a corporation’s shareholders are personally liable. For instance, if an individual member or shareholder treats the corporation as its alter ego, by co-mingling funds, a court may likely pierce the corporate veil and find personal liability.
Under Georgia law, a party attempting to pierce the corporate veil must show abuse of the corporate form by proving the disputed corporation is either:
- A mere instrumentality or alter ego of its individual members and shareholders; or
- Failure to pierce this veil would result in fraud or injustice.
The Alter Ego Theory requires a showing that the owners or shareholders of a corporation disregarded the needs of the entity by using the corporation for personal transactions or dealings. An alter ego exists when a corporation’s purpose or use reflects the personal dealings of its individual members or shareholders. Courts use several factors to determine an entity as an alter ego of its owners or shareholders. These factors include, but are not limited to, the commingling of funds, an entity’s failure to follow formalities, and undercapitalization.
Commingling of Funds
Most often, courts inquire as to whether members or shareholders have used company funds for the payment of personal expenditures unrelated to the entity itself. Commingling of funds not only disrupts the intent of the entity but could hinder the corporation from affording its own operational fees and expenses. An option to avoid this infraction is by refraining from paying personal expenses out of the entity’s checking account. The entity’s funds should only be used for the corporation’s expenses. It is vital for the businesses and affairs of each member, shareholder, or director to define a sharp line, separating individuals from the entity itself.
Failure to Follow Formalities
In opting to form a corporation, members, shareholders, and directors commit themselves to the formalities entailed in formation. Thus, as members of an entity, thorough records of the corporation’s Director-approved activities, balance sheets, annual reports, Board meetings, and meeting minutes should always be maintained to guarantee the entity’s individual identity. A mistake many members of corporations make is to never record the actions of an entity. The drawback to this decision is the individual’s inability to later prove to the Court the separation and distinction between personal decision making and decisions made for the benefit of the entity.
Courts will look at the overall operation of an entity to determine whether enough funds have been applied to cover the foreseeable operational fees and expenses of the entity. This means, if your corporation year after year fails to maintain adequate funds- it could be an indicator of reckless commingling between accounts. This inquiry, however, is not dispositive of abuse. Instead, additional evidence must be provided to show an intent of owners or shareholders to improperly avoid futures debts of the corporation.
Preventing Fraud or Injustice
Further, piercing of the corporate veil is permitted if a member or shareholder has overextended privileges by using the corporation to defeat justice, perpetuate fraud, or evade contractual or tort responsibility. Fraud or injustice requires more than failing to pay a creditor. A paramount indicator of fraud or injustice used by the Courts is the commingling of funds. For example, an individual cannot create a corporation but continue operating the entity out of his or her personal checking accounts or using the entity’s assets as its own personal assets. Courts may look at this practice as complete disregard of the separation between entity and individual member. Further, an indicator of this fraud or injustice appears in circumstances where a member sets up numerous corporations and then drains the funds or assets from one corporation in order to avoid liability incurred from another corporation.
While courts have historically been hesitant to get involved in business decisions of a corporation, there are situations in which the court finds it appropriate to intervene and “pierce the corporate veil.” As such, it is important for members of a corporation to be diligent in separating funds, capitalizing the corporation, abstaining from fraudulent behavior and keeping proper records.