In Arizona, as in many other jurisdictions, the limited liability afforded by a corporation may sometimes be removed through a legal doctrine known as “piercing the corporate veil.” Since limited liability is one of the primary reasons people incorporate, to have the corporate veil pierced and liability attach to the officers, directors or shareholders is a substantial detriment. People who own or operate corporations should know how to avoid being the target of a piercing the corporate veil claim.
Piercing the corporate veil is not easy, but in some situations it is not difficult because the owners of the corporation do such a bad job of forming or maintaining the corporation. Just because you file papers with the Arizona Corporation Commission to form a corporation does not mean that you are in the clear. If your corporation was not formed by a reputable lawyer, you are likely at some risk.
We have successfully pierced the corporate veil for clients. We have educated numerous clients about piercing the veil, and how to form and operate a corporation that will stand efforts to pierce the veil.
Accountants who incorporate corporations are generally more familiar with tax issues than with arcane legal concepts such as “piercing the corporate veil.” Paralegals may know how to fill out forms, but it is doubtful any paralegal is knowledgeable about the intricacies of piercing the corporate veil doctrine. Do-it-yourselfers lack the legal skill, training and experience that is necessary to prevent a piercing the corporate veil claim from having merit.
The Arizona law regarding a corporate entity and piercing the corporate veil is more easily stated than it is applied. As a general rule, a corporation will be treated as a separate legal entity until sufficient reason appears to disregard the corporate form. In Arizona, there are two (2) legal grounds for disregarding the corporate form: 1) alter ego status or 2) undercapitalization at inception.
The corporate fiction will be disregarded when the corporation is the alter ego or business conduit of a person, and when to observe the corporate form would work an injustice. The alter ego status is said to exist when there is such unity of interest and ownership that the separate personalities of the corporation and owners cease to exist.
How do you know whether alter ego status exists? That is not always an easy question to answer, but the more wrong things the corporation and its principals do, the more likely it is that alter ego status will be found to exist. Here are some of the things to look for:
1. Were Bylaws properly prepared and adopted?
2. Were stock certificates actually issued to all of the stockholders?
3. Are minutes of company meetings prepared and kept in the company record book?
4. Is there a corporate record book containing the Articles of Incorporation, Bylaws, Minutes of meetings and Stock Register?
5. Are personal debts paid from a corporate checking account?
6. Are there formal corporate resolutions for such things as land transactions, leases and loans?
7. Are loans to insiders properly documented and adequately secured by collateral?
8. Are corporate funds and personal funds commingled?
9. Are there records showing that the corporation was properly capitalized?
10. Is the President of the corporation the same person as the Secretary of the corporation?
In addition, would observing the corporate form sanction a fraud or promote injustice in the particular circumstances? The more evidence you have to show a fraud or injustice, the more likely it is that a court will disregard the corporate form.
The doctrine of “piercing the corporate veil” based on alter ego and fraud does not apply to claims asserted by corporate shareholders. This doctrine is only available to third parties, such as creditors, who deal with the corporation.
All Arizona corporations must be established on an adequate financial basis. At the time of formation, the corporation must be properly capitalized. This means that the assets used to fund the corporation must bear a reasonable relation to the anticipated liabilities of the corporation. For example, a corporation formed to engage in a hazardous activity, such as transporting corrosive chemicals, must have sufficient assets to respond to claims arising out of the corporation’s business. A corporation that was formed for the purpose of selling greeting cards is likely to need less capital than a hazardous chemical transporter.
There is no bright line to establish how much capital is enough and how much is not enough. The more capital the corporation has, however, the merrier. Depending upon the nature of the business, ten thousand dollars ($10,000.00) or even fifty thousand dollars ($50,000.00) may not be enough.
The test of capitalization is at inception, not some time later. Thus, a corporation that was properly capitalized but later runs out of money and assets cannot have its veil pierced on an undercapitalization basis. A corporation that was undercapitalized at its inception is always subject to attack, no matter how well it does financially later.
For a good explanation of the undercapitalization theory, see Norris Chemical Company v. Ingram, 139 Ariz. 544, 679 P.2d 567 (App. 1984).
The moral of the story is that a corporation will not shield you from personal liability unless you do things right. The corporation must be properly formed. And, the corporation must be properly maintained. A corporation that is undercapitalized at inception or that is the alter ego of its principals may be an easy target for a piercing the corporate veil claim.