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General rule: Limited liability of shareholders.

California law allows individuals to create and use corporations for a variety of purposes, one being limitation of personal liability. Acco Contractors, Inc. v McNamara & Peepe Lumber Co. (1976) 63 CA3d 292, 296. A corporation and its shareholders are distinct and separate entities. Merco Constr. Eng’rs, Inc. v Municipal Court (1978) 21 C3d 724. A key principle of corporate law is that a shareholder is not personally liable for the obligations and torts of the corporation beyond the extent of the shareholder’s investment in the corporation. Wyatt v Union Mortgage Co. (1979) 24 C3d 773.

Limited liability not absolute or automatic. Limited liability serves the important public policy of encouraging investment by limiting risk. However, limited liability for shareholders is not absolute or automatic and can be defeated in instances when the corporation is deemed to be a mere alter ego of the shareholders. The equitable power of a court to ignore the corporate form in these instances is colloquially known as “piercing the corporate veil.” See Automotriz del Golfo de Cal. S.A. de C.V. v Resnick (1957) 47 C2d 792, 796. The origin of the phrase “piercing the corporate veil” is uncertain. The reference to the veil and those “who stand behind it” seems to first appear in Bank of U.S. v Deveaux (1809) 9 US 61, 75, although the metaphor reportedly was in circulation even earlier.


Two-Part Test
Courts apply what is referred to as the “alter ego” doctrine to decide whether a corporation’s veil should be pierced (i.e., whether the corporate identity should be disregarded and liability placed on the shareholders). This doctrine provides that the corporate veil may be pierced when:

  • There is such a unity of interest and ownership between the corporation and its shareholders that they have no separate existence; in essence, the shareholders have treated the corporation as their alter ego; and
  • It would sanction a fraud or promote an injustice to uphold the corporate entity and permit the shareholders to escape personal liability for its obligations. Mesler v Bragg Mgmt. Co. (1985) 39 C3d 290, 300; Automotriz del Golfo de Cal. S.A. de C.V. v Resnick (1957) 47 C2d 792, 796; Triyar Hospitality Mgmt., LLC v WSI (II)–HWP, LLC (2020) 57 CA5th 636, 643 (overwhelming evidence of unity of interest and ownership such that separate personalities of judgment debtor and owners did not exist); Sonora Diamond Corp. v Superior Court (2000) 83 CA4th 523, 538. See also Leek v Cooper (2011) 194 CA4th 399, 418 (affirming decision denying plaintiff’s motion to amend complaint to add alter ego allegations when plaintiffs failed to show evidence of inequitable result or some conduct amounting to bad faith).
    NOTE: Federal law has a slightly different formulation. A court weighing whether to pierce the corporate veil will consider three factors: ”

    • [1] the amount of respect given to the separate identity of the corporation by its shareholders,
    • [2] the degree of injustice visited on the litigants by recognition of the corporate entity, and
    • [3] the fraudulent intent of the incorporators.” UA Local 343 v Nor-Cal Plumbing, Inc. (9th Cir 1994) 48 F3d 1465, 1475; Politte v U.S. (SD Cal 2012) 2012–1 USTC ¶50,262, 109 AFTR2d 1454, aff’d (9th Cir 2014) 114 AFTR2d 6816 (unpublished), aff’d (9th Cir 2015) 2015–1 USTC ¶50,198 (unpublished).

Presumption of Corporation’s Separate Existence

Because the law recognizes the corporation as a separate legal entity and specifically permits owners to incorporate a business for the very purpose of shielding them from its liabilities, some courts have called piercing the corporate veil “an extreme remedy,” to be “sparingly used.” Sonora Diamond Corp. v Superior Court (2000) 83 CA4th 523, 539, citing Calvert v Huckins (ED Cal 1995) 875 F Supp 674, 678. See also Hasso v Hapke (2014) 227 CA4th 107, 155. It has been said that the remedy “does not guard every unsatisfied creditor of a corporation,” but is triggered only when fraud or bad faith is present. Sonora Diamond Corp. v Superior Court, supra, citing Associated Vendors, Inc. v Oakland Meat Co. (1962) 210 CA2d 825, 842. Thus, the burden of pleading and establishing alter ego liability is on the plaintiff creditor. See Mid-Century Ins. Co. v Gardner (1992) 9 CA4th 1205, 1212; Pearl v Shore (1971) 17 CA3d 608.

 Who Can Be Held Liable

  • Shareholders, parent and successor corporations, promoters. If unity of interest and fraud or injustice are established , a controlling shareholder, parent corporation, successor corporation, or promoter may be held liable for the acts of the corporation. See, e.g., Engineering Serv. Corp. v Longridge Inv. Co. (1957) 153 CA2d 404 (shareholder); McLoughlin v L. Bloom & Sons (1962) 206 CA2d 848 (parent corporation); Cleveland v Johnson (2012) 209 CA4th 1315; McClellan v Northridge Park Townhome Owners Ass’n (2001) 89 CA4th 746 (successor corporation); Minton v Cavaney (1961) 56 C2d 576 (promoter).
  • Tort and contract liability. The doctrine can be applied to impose liability for torts as well as contracts. See, e.g., Mesler v Bragg Mgmt. Co. (1985) 39 C3d 290 (strict product liability and negligence). See also §1A.10.

 Ownership or Control

The requirement that there be a unity of ownership and interest is usually demonstrated by the ownership by an individual or another entity of the stock of the corporation, and if that is absent, the alter ego doctrine is usually unavailable. CADC/RADC Venture 2011-1 LLC v Bradley (2015) 235 CA4th 775, 788. However, ownership of one share can be sufficient to find the defendant liable. Riddle v Leuschner (1959) 51 C2d 574.

Share ownership may not be essential, however, if the defendant exercises control. See Minton v Cavaney (1961) 56 C2d 576 (defendant attorney was director and secretary of corporation that issued no shares); Goldsmith v Tub-O-Wash (1962) 199 CA2d 132 (corporate shares were held in name of defendant’s daughter and son-in-law, but paid for by defendant, who controlled corporate activities). Compare Riddle v Leuschner (1959) 51 C2d 574 (defendant was president and general manager, but did not own any shares of corporation; alter ego judgment reversed).

Participation Required for Liability; Amendment of Judgment

Participation in conduct required.

To be liable, the shareholder must have participated in the conduct constituting the abuse of the corporate privilege. See, e.g., Pearl v Shore (1971) 17 CA3d 608, 614 (defendant was 25 percent shareholder but had nothing to do with day-to-day operation of corporation and was legal stranger to plaintiff; held not liable as corporation’s alter ego). See also Firstmark Capital Corp. v Hempel Fin. Corp. (9th Cir 1988) 859 F2d 92; American Home Ins. Co. v Travelers Indem. Co. (1981) 122 CA3d 951.

Additional judgment debtors; virtual representation. In the context of a lawsuit that has been prosecuted to judgment, if the court amends the judgment to add a judgment debtor on the basis of alter ego, due process requires a finding that the additional judgment debtor controlled the litigation in its capacity as alter ego and was thus “virtually represented” in the lawsuit. Baize v Eastridge Cos. (2006) 142 CA4th 293, 302, citing NEC Electronics, Inc. v Hurt (1989) 208 CA3d 772, 778. In Baize, the court concluded that there was sufficient evidence to add a company called TECLA to a judgment against a company called TEC because of common

  • ownership,
  • officers, and directors and
  • shared employees,
  • shared offices, and
  • shared attorneys.

In addition, the evidence showed that within the TEC family of entities, accounting entries were made to shift revenue and profits freely for the tax and corporate benefit of the entities and their owners. Moreover, there was evidence that one of the TEC entities claimed it was the developer on projects that TECLA was developing, suggesting that TEC considered all of its related entities to be one and the same. See also Triyar Hospitality Mgmt., LLC v WSI (II)–HWP, LLC (2020) 57 CA5th 636, 643 (owners had control of underlying litigation and were virtually represented); Misik v D’Arco (2011) 197 CA4th 1065, 1075; Leek v Cooper (2011) 194 CA4th 399.

Shareholders of public corporations.

There does not appear to be any case reported in California in which passive shareholders of a publicly traded corporation have been held liable for its debts under the alter ego doctrine. See Bainbridge, Abolishing Veil Piercing, 26 J Corp L 479, 482 (2001) (“Shareholders of public corporations are effectively immune from veil piercing claims”).

Parent/Subsidiary and Sister Corporations

Parent/subsidiary corporations.

In general, a parent corporation will not be held liable for its subsidiary’s debts merely because of its stock ownership or because the parent and subsidiary have common directors or officers. Alter ego liability will be imposed only if

  • the parent controls the subsidiary to such a degree that it is a “mere instrumentality,” agency, conduit, or adjunct of the parent;
  • the parent uses the subsidiary for an improper purpose; and
  • an inequitable result would follow unless the parent were held liable. Laird v Capital Cities/ABC, Inc. (1998) 68 CA4th 727, 742; Tomaselli v Transamerica Ins. Co. (1994) 25 CA4th 1269, 1285.If a parent corporation owns or controls all of a subsidiary’s stock and operates that subsidiary in a way that renders the subsidiary as a mere alter ego of its parent, courts will pierce the corporate veil and treat the two corporations as a single entity. Davidson v Seterus, Inc. (2018) 21 CA5th 283, 305; Sonora Diamond Corp. v Superior Court (2000) 83 CA4th 523, 538. In Mesler v Bragg Mgmt. Co. (1985) 39 C3d 290, the court held that a plaintiff could pursue a tort action against a parent corporation on the theory that it was the alter ego of its subsidiary (the alleged tortfeasor) despite having entered into a settlement and release with the subsidiary. Nonetheless, treating one corporation as the alter ego of another has been characterized as “an extreme remedy, [to be] sparingly used.” Hasso v Hapke (2014) 227 CA4th 107, 155.

Sister corporations.

The alter ego doctrine can be applied to sister corporations through the single-enterprise rule, meaning that although there are two or more entities under common ownership, there is but one enterprise or business venture, and this enterprise has been so operated that it should be liable as a whole for the obligations of its component entities. See Hasso v Hapke, supra; Las Palmas Assocs. v Las Palmas Ctr. Assocs. (1991) 235 CA3d 1220. See also Zoran Corp. v Chen (2010) 185 CA4th 799 (question of whether corporation that assumed and failed to pay debts of two other corporations was alter ego of individual who provided its start-up funding was issue of material fact precluding summary judgment).

Personal jurisdiction.

For purposes of personal jurisdiction, alter egos are treated as a single entity. Myhre v Seventh-Day Adventist Church Reform Movement Am. Union Int’l Missionary Soc’y (SD Cal 2014) 298 FRD 633, 644, quoting Cardell Fin. Corp. v Suchodolski Assocs. (SD NY, July 17, 2012, 09 Civ. 6148 (VM) (MHD)) 2012 US Dist Lexis 188295, *47). A subsidiary’s contacts may be imputed to the parent company when the subsidiary is the parent’s alter ego or when the subsidiary acts as the parent’s agent. Harris Rutsky & Co. Ins. Servs. v Bell & Clements Ltd. (9th Cir 2003) 328 F3d 1122, 1134.

Alter Ego Is an Equitable Doctrine

Equitable doctrine. The alter ego doctrine is an equitable doctrine. NEC Electronics, Inc. v Hurt (1989) 208 CA3d 772. Its purpose is that justice be done. Mesler v Bragg Mgmt. Co. (1985) 39 C3d 290. Although courts have considered many factors in justifying its application  their basic motivation is to ensure a just and equitable result. Relentless Air Racing, LLC v Airborne Turbine Ltd. Partnership (2013) 222 CA4th 811; NEC Electronics, Inc. v Hurt, supra. Citing Comment, Corporations: Disregarding Corporate Entity: One Man Company, 13 Cal L Rev 235, 237 (1925), the court in Mesler v Bragg Mgmt. Co. (1985) 39 C3d 290, 300, explained that

[i]n certain circumstances the court will disregard the corporate entity and will hold the individual shareholders liable for the actions of the corporation: “As the separate personality of the corporation is a statutory privilege, it must be used for legitimate business purposes and must not be perverted. When it is abused it will be disregarded and the corporation looked at as a collection or association of individuals, so that the corporation will be liable for acts of the stockholders or the stockholders liable for acts done in the name of the corporation.”

If the corporate form is employed to commit a fraud, circumvent a statute, or for another inequitable or wrongful purpose, the court will ignore the corporate entity and consider the actions of the corporation to be those of the entities or individuals who actually control the corporation. The alter ego doctrine thus prevents individuals or other entities from misusing the corporation laws by forming a sham entity for the purpose of committing fraud or other misdeeds. Troyk v Farmers Group, Inc. (2009) 171 CA4th 1305, 1341; Sonora Diamond Corp. v Superior Court (2000) 83 CA4th 523, 538.

Trial to judge. Alter ego being an equitable issue, it is tried to the judge, not the jury. Dow Jones v Avenel (1984) 151 CA3d 144, 147. Equitable defenses apply. See, e.g., Shapoff v Scull (1990) 222 CA3d 1457, disapproved in part on other grounds in Applied Equip. Corp. v Litton Saudi Arabia, Ltd. (1994) 7 C4th 503, 521 n10 (plaintiff who has dealt with corporation may be estopped to deny corporation’s separate existence); Alexander v Abbey of Chimes (1980) 104 CA3d 39 (failure by plaintiff to pursue alter ego claim with due diligence was defense); Wynn v Treasure Co. (1956) 146 CA2d 69 (plaintiff who had acted as officer and director of corporation was estopped to claim individual defendant was its alter ego).

§1A.9 E. Factors Considered in Piercing Corporate Veil
What evidence will lead a court to disregard the corporate form? A number of factors have been listed; many are within the control of transactional or corporate counsel. They include, but are not limited to

Commingling of corporate funds and property with the owner or with other separate entities, and the unauthorized diversion of corporate funds or assets to other than corporate uses;
Treatment by the individual of corporate assets as their own;
Undocumented diversions of corporate funds or assets that confer no benefit on the entity (e.g., payment of an individual’s mortgage or credit card bills);
Failure to maintain corporate records;
Failure to issue or subscribe stock;
Sole ownership of all of the stock in a corporation by one individual or the members of a family;
Identical ownership or control of dual or interlocking entities;
Inadequate or nonexistent capitalization;
Disregard of legal formalities;
Misrepresentation or concealment of corporate ownership or control, or of personal business activities benefiting the controlling person;
Sharing of offices and locations, or running the entity’s business out of the individual’s home;
Sharing of employees, attorneys, or other professionals;
Entering into contracts with no intention to perform, intending to use the entity as a subterfuge;
Diversion of assets from the corporation to its owner, to the detriment of creditors;
Formation of a corporation to be recipient of another person’s existing liability;
Failure to complete legal formalities required to properly incorporate;
Failure to convene meetings of shareholders or directors;
Failure to file tax returns, or pay income taxes or payroll taxes;
Manipulation of assets and liabilities between corporations so that assets are concentrated in one person or entity and liabilities are concentrated in another;
Failure to maintain arm’s-length relationships between related entities;
The use of the corporate entity to procure labor, services, or merchandise for another person or entity;
Continuation in business under a new name after insolvency; and
Occurrence of insolvency soon after incorporation.
See Relentless Air Racing, LLC v Airborne Turbine Ltd. Partnership (2013) 222 CA4th 811; Associated Vendors, Inc. v Oakland Meat Co. (1962) 210 CA2d 825, 837; Trans-World Int’l, Inc. v Smith-Hemion Prods., Inc. (CD Cal 1997) 972 F Supp 1275, 1294, aff’d (9th Cir 1999) 205 F3d 1352.

No litmus test. The above examples are illustrative, not exhaustive. No single factor is dispositive. Arnold v Browne (1972) 27 CA3d 386, disapproved in part on other grounds in Reynolds Metals Co. v Alperson (1979) 25 C3d 124, 129; Talbot v Fresno-Pacific Corp. (1960) 181 CA2d 425, 432. As the California Supreme Court has noted, “There is no litmus test to determine when the corporate veil will be pierced; rather the result will depend on the circumstances of each particular case.” Mesler v Bragg Mgmt. Co. (1985) 39 C3d 290, 300. In Kao v Joy Holiday (2020) 58 CA5th 199, the court of appeal affirmed that the owners of a closely held corporation were alter egos of the corporation and as such were personally liable for unpaid wages. There was no evidence that the corporation was undercapitalized or that the corporation was a mere shell or conduit for the owners’ business, but there was evidence of commingling of assets and unauthorized use of corporate assets to pay personal expenses, which was sufficient to show that a failure to disregard the corporate entity would lead to an inequitable result. The court of appeal held that it was the province of the trial court to determine whether the presence or absence of any factor or any other circumstance warranted invoking the alter ego doctrine.

NOTE: As noted above, the failure to observe corporate formalities is one factor among many that a court will consider in deciding whether alter ego liability should apply. For statutory close corporations, however, Corp C §300(e) states that such failure is not to be considered as a factor tending to establish that the shareholders are personally liable for corporate obligations. See chap 7 on close corporations.

§1A.10 F. Tort Versus Contract Claims
More readily imposed for tort claims. Alter ego liability may be more readily imposed for tort claims than for contract claims because, in the latter situation, the parties’ dealings with each other are consensual. As noted in Cascade Energy & Metals Corp. v Banks (10th Cir 1990) 896 F2d 1557, 1577:

The obvious difference between consensual and nonconsensual transactions is that the claimants in consensual transactions generally have chosen the parties with whom they have dealt and have some ability, through personal guarantees, security agreements, or similar mechanisms, to protect themselves from loss. For example, the fact that a company is undercapitalized can be overcome in many contractual settings, because the parties can allocate the risk of financial failure as they see fit. But in nonconsensual cases, there is no element of voluntary dealing, and the question is whether it is reasonable for business[persons] to transfer a risk of loss or injury to members of the general public through the device of conducting business in the name of a corporation that may be marginally financed.

Allowing contract creditors to recover from a shareholder’s personal assets gives them an unbargained-for windfall, unless the shareholder’s misuse of the corporate entity exposed the creditors to unexpected risk. 896 F2d at 1558.

Participation in a corporate tort. Apart from liability under the alter ego doctrine, and even when alter ego liability is not found, shareholders are personally liable if they directly “ordered, authorized or participated in” a corporation’s tortious conduct. In those instances, the shareholders’ liability does not arise from their unity of interest with the corporation, but from their own affirmative misconduct. Indeed, when shareholders are found directly liable, alter ego liability is unnecessary. Filet Menu, Inc. v C.C.L. & G., Inc. (2000) 79 CA4th 852, 866.

§1A.10A G. Tax Claims
In Brugnara Props. VI v IRS (In re Brugnara Props. VI) (Bankr ND Cal 2019) 606 BR 371, the bankruptcy court held that both the Internal Revenue Service (IRS) and the California Franchise Tax Board (FTB) could use an alter ego theory and were entitled to summary judgment against the debtor. The debtor was acting solely as a nominee for the taxpayers and served no business purpose except for holding title to the taxpayers’ residential real property. Recognition of the debtor as a separate entity from the taxpayers would have enabled the taxpayers to evade tax liability.

§1A.11 H. Use of Corporation to Evade Statute
When the corporate entity is used to circumvent a statute or frustrate a statutory policy, the court may disregard the entity and treat the acts as if they were done by the controlling shareholders. See H.A.S. Loan Serv., Inc. v McColgan (1943) 21 C2d 518 (brother/sister corporations that divided loan charges to avoid usury law regarded as single entity); Say & Say, Inc. v Ebershoff (1993) 20 CA4th 1759 (litigious shareholder used corporation to avoid “vexatious litigant” statute); People v Anderson (1991) 1 CA4th 1084 (shareholder used corporation to avoid statutory restrictions on sale of liquor license). Compare Opp v St. Paul Fire & Marine Ins. Co. (2007) 154 CA4th 71, which provides an obverse example of this point. In Opp, a corporation entered into construction contract and then, when it was not paid, sued to collect under a performance bond. However, the corporation lacked a contractor’s license, which is a statutory bar to payment under Bus & P C §7031(a). The court held that the sole shareholder and president could not claim that the corporation was merely his alter ego (154 CA4th at 76):

Parties who determine to avail themselves of the right to do business by means of the establishment of a corporate entity must assume the burdens thereof as well as the privileges. An individual who has obtained the benefits of corporate limited liability will not be permitted to repudiate corporate existence just because the corporation has become an inconvenience.

The court also rejected the shareholder’s argument that the corporate name was simply a fictitious business name under which he did his contracting work. A fictitious business name that contains the word “Inc.” cannot be registered by an individual. Bus & P C §17910.5(a).

§1A.12 I. Effect of Finding Alter Ego Liability
Shareholders may be jointly and severally liable. When the court finds that the alter ego doctrine applies, the corporation’s shareholders may be treated as partners operating through a corporate form and held jointly and severally liable for its debts. Minnesota Mining & Mfg. Co. v Superior Court (1988) 206 CA3d 1025. But see §1A.15.

Liability limited to particular case. Application of the alter ego doctrine is limited to the particular case and particular facts before the court. When the court finds the defendant to be the corporation’s alter ego, it does not dissolve the corporation; it simply disregards the liability shield that the corporate entity would otherwise provide, so that justice may be done for the plaintiff. A judgment against a corporation and its alter ego is enforceable against each separately. For all other purposes, the corporate entity remains intact. Mesler v Bragg Mgmt. Co. (1985) 39 C3d 290, 304.

Inadequate capitalization or undercapitalization is often cited as a basis for piercing the corporate veil. California courts have placed significant weight on this factor. See Minton v Cavaney (1961) 56 C2d 576; Pearl v Shore (1971) 17 CA3d 608, 616.

§1A.14 A. Automotriz Case
Leading case on undercapitalization. Analysis of the role of undercapitalization as a factor in alter ego liability begins with a California Supreme Court case involving a failed automobile sales business. Automotriz del Golfo de Cal. S.A. de C.V. v Resnick (1957) 47 C2d 792, 796. The plaintiff corporation, Automotriz del Golfo de California S.A. de C.V. (Automotriz), sought to hold the shareholders of the defendant, Erbel, Inc. (Erbel), liable for Erbel’s debts. Erbel’s shareholders operated an automobile sales business that generated over $100,000 per month. On its formation, Erbel’s shareholders invested only $5000 of initial capitalization into the corporation. Erbel’s business eventually failed, and Erbel could not pay its creditors. Automotriz, a creditor of Erbel, recognized that recovery from the corporation was unlikely and sought redress from Erbel’s shareholders. The trial court determined that Erbel’s shareholders were liable for Erbel’s debts. On appeal, the California Supreme Court upheld the trial court’s determination.

Two justifications for piercing the veil. In Automotriz, the court examined two particular justifications for piercing Erbel’s corporate form: (1) Erbel failed to issue stock and (2) Erbel was undercapitalized. In its analysis of these issues, the court announced that, as a rule, undercapitalization is an important factor in deciding whether to pierce the corporate veil. If a corporation transacts business with insufficient capital in such a way as to have no sufficient means available to meets its debts, the court concluded that it would be inequitable to allow the corporation’s shareholders to avoid personal liability to the corporation’s creditors. Accordingly, shareholders should put at risk adequate unencumbered capital to reasonably cover prospective liabilities of the corporation. Their failure to do so can be considered as a factor for denying the protection of limited liability. 47 C2d at 796.

Outcome. In applying the law to the facts of the case, the Automotriz court held that, based on the combination of the corporation’s failure to issue stock and, considering the corporation’s volume of business, the insufficiency of $5000 of capitalization to cover the corporation’s prospective liabilities, the corporation was the alter ego of the shareholders, and, therefore, the shareholders were liable for the corporation’s debts. 47 C2d at 797.

§1A.15 B. Minton Case
Wrongful death case; relief sought against corporate director. Four years following its decision in Automotriz (see §1A.14), the California Supreme Court decided another case, Minton v Cavaney (1961) 56 C2d 576, in which the factor of undercapitalization also played a significant role. Minton was a wrongful death case in which the plaintiff’s daughter died in a swimming pool accident. At trial, the court awarded a $10,000 judgment against the Seminole Hot Springs Corporation (Seminole). The judgment went unsatisfied, and the plaintiff brought an action against the estate of a Seminole director, Cavaney. Seminole had applied to the Commissioner of Corporations for permission to issue stock to Cavaney, but permission was denied pending submission of further information. Nonetheless, the trial court found that Cavaney was an equitable owner and entered a judgment against the estate for $10,000. The estate of Cavaney appealed.

Alter ego factors. The California Supreme Court reversed the judgment against Cavaney’s estate because the estate was not given an opportunity to litigate the issues of Seminole’s negligence or the plaintiff’s damages. Nevertheless, the court listed a number of instances when a corporation’s equitable owners could be held liable for the debts of a corporation (56 C2d at 579):

When there is inadequate capitalization, and the shareholders of the corporation actively participate in the conduct of corporate affairs;
When shareholders of the corporation hold themselves out as personally liable; or
When the shareholders of the corporation treat the assets of the corporation as their own by shifting assets at will.
Undercapitalization was principal factor in Minton. In Minton, of these factors, only undercapitalization was present. The court acknowledged that Seminole’s capital was “trifling” compared with the business undertaken and the potential risks of loss and determined that there was no attempt to provide adequate capitalization for the business. 56 C2d at 580. Moreover, the court pointed out that, despite the estate’s contention that Cavaney participated in the corporation solely as temporary director, two activities were evidence that he actively participated in the conduct of the business: (1) his participation as secretary, treasurer, and director; and (2) his retention of the corporation’s records.

Minimal participation by shareholders. In Minton, the court required only minimal participation to satisfy the requirement that shareholders actively participate in the conduct of corporate affairs. Minton may be considered to stand for the proposition that undercapitalization alone may justify piercing the corporate veil. This proposition is echoed in a Ninth Circuit case that noted that undercapitalization of a subsidiary alone can be justification for holding the parent corporation liable. Slottlow v American Cas. Co. (9th Cir 1993) 10 F3d 1355, 1360 ($500,000 initial capitalization “woefully inadequate” for corporate trustee for investors in loan pools). But see Cambridge Electronics Corp. v MGA Electronics, Inc. (CD Cal 2004) 227 FRD 313; Mid-Century Ins. Co. v Gardner (1992) 9 CA4th 1205, 1213 (cautioning against relying too heavily in isolation on factors of inadequate capitalization or concentration of ownership control). However, because the court in Minton held that the shareholder’s estate was not liable for the corporation’s liability on that particular occasion, the court’s opinion on factors relevant to piercing the corporate veil was arguably not essential to the court’s decision, and hence may constitute dicta.

Which shareholder(s) should bear liability? In deciding to pierce the veil, courts must also decide on whom the liabilities of the corporation fall. Under a Minton rationale, courts place the liability on the equitable owners who actively participate in the corporate affairs. By implication, Minton suggests that an owner with a controlling interest who chooses not to be involved in the operation of the corporation would not be liable under an alter ego theory. This approach encourages active investors to provide an adequate level of assets for the corporation and protects passive investors from additional liability.

§1A.16 C. Wheeler and Harris Cases
Other factors considered. California courts have not uniformly followed the guidelines for piercing the corporate veil as set forth in Minton (see §1A.15). Instead, courts have regularly considered a number of other factors to determine the degree to which a corporation is controlled by its equitable owners and whether there was fraud or confusion in the corporation’s dealings with the plaintiff. See Associated Vendors, Inc. v Oakland Meat Co. (1962) 210 CA2d 825, 837; see also §§1A.5, 1A.9.

Wheeler: Undercapitalization was sole factor. Shortly after Minton, the Second District Court of Appeal decided Wheeler v Superior Mortgage Co. (1961) 196 CA2d 822. In Wheeler, the plaintiff brought an action against two mortgage companies and their shareholders for a usurious loan. He prevailed at trial, and the trial court determined, among other things, that the mortgage companies’ shareholders were liable to him because the mortgage companies were alter egos of their shareholders. In deciding that the shareholders were liable for the usurious loans of the mortgage companies, the Wheeler court relied on the rule as iterated in Automotriz: The court may consider the fact that a corporate entity is undercapitalized and thus may deny limited liability protection. The Wheeler court determined that the mortgage companies were significantly undercapitalized. In fact, the court stated that at the time of the loans “neither corporation had any capitalization whatsoever.” 196 CA2d at 831. In Wheeler, however, unlike in Automotriz, the stock of the companies was properly issued to the shareholders. Accordingly, to determine that the company was the alter ego of the shareholder, the Wheeler court could rely only on undercapitalization to justify piercing the corporate veil. Under the “unity of interest” test of the alter ego doctrine (see §1A.2), the Wheeler court found for the plaintiff based solely on undercapitalization. The court had no trouble concluding that the second test for alter ego liability had been met (i.e., inequitable result), given that corporations were “used for the very purpose of making usurious loans.” 196 CA2d at 830.

Harris: Other important factors. In Harris v Curtis (1970) 8 CA3d 837, the plaintiff, Harris, sued the defendant corporation, Tagus Ranch Motel Corporation (TRMC), and various shareholders for return of funds advanced to TRMC. The trial court ruled that Harris could not pierce TRMC’s limited liability protection, and Harris appealed. Although TRMC operated a motel and restaurant business with assets of $393,000, liabilities of $455,000, and gross sales of $215,000 over the prior 8 months, it had only been capitalized with $1000. However, the Harris court relied heavily on findings by the trial court that examined a multiplicity of factors other than undercapitalization in its alter ego analysis. Harris argued, citing a number of cases (including Automotriz and Wheeler), that undercapitalization in and of itself rendered the shareholders liable for the obligations of TRMC. The court of appeal distinguished each of the cases cited by the plaintiff and disagreed with the plaintiff’s analysis. The court distinguished Harris from Automotriz because no stock was ever issued in Automotriz, but stock was issued in Harris. The court also used Wheeler to support its contention that the court may consider that the corporate entity was undercapitalized, and that undercapitalization is one ground for piercing the veil. The Harris court refused to pierce the company veil and hold the shareholders of TRMC liable. Although the court acknowledged that TRMC was underfinanced, it noted that this condition is not uncommon among new small businesses and that there were a number of factors that weighed against piercing the company veil, including no commingling of assets, no unauthorized diversion of corporate funds, and the fact that the corporation was not used as a subterfuge for illegal transactions. 8 CA3d at 840. As a result, California courts remain split on whether undercapitalization is, in and of itself, enough to require or allow a court to pierce the corporate veil. Nevertheless, it is clear that California courts view undercapitalization as an important factor in such a decision.

§1A.17 D. Measuring Adequacy of Capital
Whether undercapitalization is the sole factor or one of a group of factors in determining a veil piercing case, measuring the adequacy of capital is no simple task. The following issues are part of that process:

How should the assets of the corporation be analyzed?
Is adequate capitalization merely a concern at formation, or is it an ongoing concern throughout the life of a corporation?
§1A.18 1. Analysis of Assets
Capitalization unreasonably small. In Automotriz del Golfo de Cal. S.A. de C.V. v Resnick (1957) 47 C2d 792, 797, the court stated: “If the capital is illusory or trifling compared with the business to be done and the risks of loss, this is a ground for denying the separate entity privilege.” However, the law does not require the corporation be capitalized to withstand any and all setbacks; rather, capitalization must not be unreasonably small. Credit Managers Ass’n v Federal Co. (CD Cal 1985) 629 F Supp 175, 183.

How much capital is adequate? In determining the adequate level of assets, courts have often used descriptive terms to characterize inadequate capitalization. Terms such as “grossly undercapitalized,” “illusory,” and “trifling” make for flowery prose but do not provide much help in analyzing exactly how much capital is enough to adequately capitalize a corporation. As noted in 2 Ballantine & Sterling, California Corporation Laws §298.02 (4th ed 1962):

Although courts frequently cite inadequate capital or capitalization as an important factor, they seldom define the term. Generally, adequacy of capital implies corporate assets sufficient for the conduct of the business. Inadequate assets or excessive debt or liability financing at the time of formation may suggest insufficient protection of creditors or tort victims. Adequate capitalization can be supplied through a mix of equity, indebtedness, insurance, or otherwise.

Evidence of undercapitalization. To determine whether a corporation is adequately capitalized, courts have relied on the testimony of financial experts (see Costello v Fazio (9th Cir 1958) 256 F2d 903, 908) and statistics comparing comparable businesses. There are a number of tests and data criteria on which experts opine, including the capitalization of other similar businesses and the average industry-wide ratios published by Moody’s or Standard & Poor’s, such as the current ratio, acid-test ratio, or debt/equity ratio. Olthoff, Beyond the Form—Should the Corporate Veil be Pierced?, 64 UMKC L Rev 311, 330 (1995). Generally, courts recognize that the process of determining whether there is sufficient capital is based in fact and on case-by-case analysis.

§1A.19 2. Initial or Ongoing Concern
When should capitalization be measured? Nationally, courts are divided with regard to whether a corporation has a duty to maintain a certain level of capitalization. In some cases, courts look only at the initial capital investment of the shareholders. Under this approach, if the risk or nature of the business changes, the investors owe no continuing obligation. See Benjamin v Diamond (In re Mobile Steel Co.) (5th Cir 1977) 563 F2d 692, 703.

Should capitalization be an ongoing concern? Conversely, some courts have held that adequate capitalization is an ongoing concern for the corporation and its investors. DeWitt Truck Brokers, Inc. v W. Ray Flemming Fruit Co. (4th Cir 1976) 540 F2d 681, 686 (duty to provide adequate capitalization begins at inception and is continuing obligation). These decisions rest on the premise that as the business risks of a corporation change, the corporation owes its creditors a duty to guard against increased risks with the infusion of additional capital investments. This duty to continuously infuse the corporation with capital is in addition to the corporation’s duty not to intentionally deplete its initial capital. Note, however, that the court in Laborers Clean-Up Contract Admin. Trust Fund v Uriarte Clean-Up Serv., Inc. (9th Cir 1984) 736 F2d 516, 525, implied that the court would be more sympathetic to the shareholders of a corporation that was once adequately capitalized, “but subsequently fell upon bad financial times.” Nevertheless, the prudent California business owner should seek to maintain an adequate level of capital.

§1A.20 3. Statistics
Researchers have performed statistical analysis regarding the success of and reasons given by courts for the decision to pierce the veil. Although such analysis is far from perfect due to the limitations of the methodology used, the variety of causes of action, the many factors distinguishing public and private corporations, and the business decisions involved in pursuing a claim, the results are revealing. Nationwide, courts pierce the veil about 48 percent of the time. In California the percentage is slightly higher than the national average at approximately 51 percent. Oh, Veil Piercing, 89 Texas L Rev 81, 114 (2010). The fewer the number of shareholders, the more likely a piercing case will succeed. See Thompson, Piercing the Corporate Veil: An Empirical Study, 76 Cornell L Rev 1036 (1991). Veil piercing claims arise more frequently in contract cases than in tort cases, but the rate of success in tort cases is slightly higher (approximately 48 percent for tort cases versus approximately 46 percent for contract cases). 89 Texas L Rev at 124.

NOTE: Courts should be less inclined to pierce the corporate veil in contract cases because the plaintiff presumably knew it was contracting with a corporation and had an opportunity to conduct due diligence into the corporation’s financial condition. See §1A.10.

See also Matheson, Why Courts Pierce: An Empirical Study of Piercing the Corporate Veil, 7 Berkeley Bus L J 1 (2010) (using multiple regression analysis to predict likelihood of veil piercing). Notably, one such study has claimed that its methodology and analysis show that in no piercing cases, out of the 9380 judicial opinions included as part of the study, was the corporate veil pierced solely because a corporation was undercapitalized. Macey, Finding Order in the Morass: The Three Real Justifications for Piercing the Corporate Veil, 100 Cornell L Rev 99, 103, 128 (2014) (with respect to Minton specifically (see §1A.15), the authors posit that Seminole’s failure to establish a sufficient number of directors under Corp C §800 was a more compelling basis, as compared to undercapitalization, to disregard the corporate form).

§1A.21 E. Tax Risks of Undercapitalization
Capitalization is key initial decision. A central decision in capitalizing a new corporation is the mixture of debt and equity that will be used. See §§1.144–1.155. Equity participation involves an ownership interest in the corporation. Normally, it is reflected by issuance of shares of stock, either common or preferred. Debt participation involves only a loan of money or other property to the corporation. Holders of debt instruments are creditors of the corporation and are typically not entitled to any voice in management and control.

Advantages of debt capital. Debt has advantages for both the corporation and its lenders. From the corporation’s point of view, the major advantage of debt over equity is that the corporation can deduct interest payments on debt, but not dividends paid on equity shares. See IRC §163(a). For the investor, casting some or all of the investment in the form of debt has several advantages:

Debt usually has repayment priority over equity contributions;
Its time of repayment can be specified and predicted;
The repayment of the principal is not a taxable event; and
If the corporation fails to make repayment, the loss can be treated as an ordinary business bad debt deduction instead of a capital loss from worthless stock.
Tax issue if debt-equity ratio too high. However, too high a ratio of debt to equity, particularly when the funds are loaned by insiders, may suggest to the IRS or to the courts that contributions characterized as debt are really equity. See IRC §385(b) (setting forth five factors for distinguishing between debt and equity). The IRS is not bound by the corporation’s characterization of capital as equity or debt. IRC §385(c)(1). The burden of establishing that amounts advanced to the corporation were loans rather than capital contributions rests on the taxpayer. Hardman v U.S. (9th Cir 1987) 827 F2d 1409, 1412. A debt-equity ratio that is too high is sometimes referred to as “thin capitalization.”

Consequences of “thin capitalization.” If the capitalization is too “thin,” the IRS may treat all or some portion of the “debt” as stock, so that “interest” deductions claimed by the corporation (IRC §163(a)) will be disallowed, and “loan repayments” will be treated as taxable dividends to the shareholders. The IRS examines shareholder loans carefully to determine whether amounts paid to the shareholder/creditor are really a distribution of profits (dividends) rather than interest. See §§1.144–1.147 for further discussion of the advantages and disadvantages of debt versus equity in planning a corporation’s initial capitalization.

Tax issues distinct from alter ego issue. A corporate entity may be recognized for tax purposes, yet be deemed the alter ego of its shareholders, making them individually liable for its taxes. See Wolfe v U.S. (9th Cir 1986) 798 F2d 1241, 1243 (not inconsistent to view corporation as viable for purpose of assessing corporation tax, while disregarding it for purpose of satisfying that assessment).

§1A.22 F. Subordination of Shareholder Loans
If a corporation is too thinly capitalized (e.g., mostly loans from shareholders, very little capital stock), the shareholder-held debt may be subordinated to the claims of other creditors if the corporation becomes insolvent. This may happen even if the shareholders’ loans are secured and the other creditors’ loans are unsecured. See Taylor v Standard Gas & Elec. Co. (1939) 306 US 307, 322, 59 S Ct 543; Pepper v Litton (1939) 308 US 295, 312, 60 S Ct 238. Subordination is an equitable remedy, and therefore usually requires a showing of bad faith in the undercapitalization, or breach of fiduciary duty to the creditors involved. Mid-Century Ins. Co. v Gardner (1992) 9 CA4th 1205, 1213; Commons v Schine (1973) 35 CA3d 141, 145.

§1A.23 G. Recommendations
Adequate capitalization is a function of the size, nature, and reasonably expected hazards and risks of the specific business being evaluated. The statistics indicate that undercapitalization is a leading factor cited by courts in veil-piercing cases. Accordingly, the amount of capital provided to a corporation is a critical decision. Directors, officers, and shareholders should carefully consider the adequacy of their corporation’s assets, the formalities by which they treat those assets, and whether adding additional capital is appropriate. The size and type of business operations and the availability and amount of liability insurance will be important factors in determining how much capital is sufficient. Unfortunately, neither statutory or case law, nor the accounting profession, offers any bright line tests or safe harbors on which one can rely, but this is not terribly surprising given the equitable nature of the remedy. The author recommends that businesses make such decisions carefully in consultation with their accountants or financial advisers. It is also prudent for a new business owner (before forming a limited liability entity) to prepare the following items:

A budget showing the business’s need for equipment, furniture, supplies, and other assets; and
A forecast of anticipated operating revenue and expenses.
“Asset protection” strategies. Recent years have seen a proliferation of advertising by so-called asset protection lawyers. Advertisements in newspapers, on the Internet, and on municipal buses urge the reader to “protect your hard-earned assets” from, e.g., creditors, divorced spouses, or the tax collector. Lawyers who practice in this murky (and risky) area create Nevada corporations, revocable and irrevocable trusts, and corporations in foreign jurisdictions, including, among others, Caribbean nations, Hong Kong, and Liechtenstein. Some claim that favorable tax treatment or other justification is the reason for directing money and assets offshore. But it appears that the real reasons have more to do with banking secrecy and insulation from creditors, and sometimes the prying eyes of the U.S. government.

Fraudulent transfer issues. In situations in which bona fide third party creditors are disadvantaged by these manipulations, alter ego doctrines go hand in hand with the law of fraudulent transfers. A detailed discussion of transfers in fraud of creditors is outside the scope of this chapter. Briefly, the Uniform Voidable Transactions Act (CC §§3439–3439.14) allows a court, subject to certain requirements, to reverse transfers of money or property that violate the Act. Under CC §3439.04, transfers are reversible in two circumstances:

If a challenged transfer was made with “actual intent to hinder, delay, or defraud any creditor of the debtor”; or
If the transfer was made “without receiving a reasonably equivalent value in exchange” and the transferor entity was either rendered insolvent or was left with “unreasonably small” assets in relation to its obligations.
If the transferor is in bankruptcy, 11 USC §548 gives the bankruptcy trustee additional avoidance powers.

Relationship to alter ego doctrine. As indicated in §1A.9, suspicious transfers and large distributions, loans to an insider, and questionable forgiveness of debts and obligations are all potential indications of alter ego. Sometimes, these transactions are poorly documented or undocumented. In such cases, fraudulent transfer law may supply an additional remedy to alter ego. Even if assets have been transferred beyond the reach of the court and creditors, there may be an additional remedy: As long as the court retains personal jurisdiction over the defendant (e.g., a U.S. resident), it can order the defendant to transfer back the funds or assets into the court’s jurisdiction, under penalty of civil and criminal contempt sanctions. See, e.g., CCP §§699.040(a), (c), 717.010.

Variant of alter ego doctrine. Under the traditional alter ego doctrine, in appropriate circumstances, courts will disregard the corporate form and pierce the veil of the corporation so that an individual shareholder may be held personally liable for a debt or liability of the company. Some courts in other states have recognized a variation of the alter ego doctrine known as reverse piercing of the corporate veil, whereby a third party creditor of an individual shareholder is permitted to pierce the company veil to reach corporate assets. In Postal Instant Press, Inc. v Kaswa Corp. (2008) 162 CA4th 1510, 1512, a California court of appeal rejected the doctrine of reverse piercing, reasoning as follows:

Outside reverse piercing can harm innocent shareholders and corporate creditors, and allow judgment creditors to bypass normal judgment collection procedures. Legal theories (such as agency or respondeat superior) and legal remedies (such as claims for conversion or fraudulent conveyance) adequately protect judgment creditors without the need to distort theories of corporate liability.

Similarly, in Phillips, Spallas & Angstadt v Fotouhi (2011) 197 CA4th 1132, 1144, the court of appeal ruled that a charging order against a partner’s interest in a partnership reached only the partner’s share in profits of the partnership. The partnership was not liable for the judgment against the partner (which would essentially be outside reverse piercing disapproved in Postal Instant Press).

Curci Invs.: Reverse veil piercing allowed. More recently, however, in Curci Invs., LLC v Baldwin (2017) 14 CA5th 214, a court of appeal concluded that reverse veil piercing is available for California judgment creditors in appropriate cases. After being awarded a multimillion dollar judgment against real estate developer James Baldwin, Curci Investments, LLC, sought to modify the judgment to add limited liability company JPB Investments LLC (JPBI) as an additional judgment debtor. Curci asserted that Baldwin held 99 percent of the interest in JPBI (with the remaining 1 percent held by Baldwin’s wife), controlled its actions, and appeared to be using JPBI as a personal bank account. Curci argued that, under these circumstances, it would be in the interest of justice to disregard the separate nature of JPBI and allow Curci to access JPBI’s assets to satisfy the judgment against Baldwin. Citing Postal Instant Press, the trial court denied Curci’s motion, based on its belief that “reverse veil piercing” is not available in California. The court of appeal found that Postal Instant Press was distinguishable, and concluded that reverse veil piercing was possible under these circumstances. First, the Postal Instant Press decision was expressly limited to corporations, and JPBI was an LLC, not a corporation. Further, there was no “innocent” member of JPBI that could be affected by reverse piercing here. Baldwin, the judgment debtor, held a 99 percent interest in JPBI, and his wife, who held the remaining 1 percent interest, was also liable for the debt owed to Curci. The court reversed and remanded for the trial court to make a factual determination whether JPBI’s veil should be pierced, taking into consideration whether Curci had any other plain, speedy, and adequate remedy at law.

Using Multiple Corporations and other Strategies

Ideally, assets, such as real estate and equipment, surplus cash, inventory, accounts receivable, and intellectual property should not be held by the operating corporation.

If the business of the corporation or LLC can be divided into separate businesses, both assets and liabilities can be protected or managed through the use of multiple entities, (which may be corporations, LLCs, limited partnerships, or trusts—all of which together are referred to as Special Purpose Vehicles or SPVs).

Improperly structured or timed, over the years, there have been many abuses of these strategies in many scandals.

  • Enron used multiple corporations and SPVs to remove liabilities from its corporate balance sheet and to disguise its growing losses from investors and regulators.
  • Lehman Brothers, in the years preceding its bankruptcy, and apparently many of the large banks, still regularly shift liabilities to SPVs prior to the end of a fiscal quarter, which effectively overstates the company’s financial strength.Despite these past and certainly ongoing abuses, SPVs allow us to accomplish many legitimate business and legal objectives. In one form or another, most businesses with valuable assets or revenues to protect use multiple corporations or SPVs for structuring flexible financing, issuing securities to investors, and achieving enhanced legal liability protection.

The simplest example of the usefulness of SPVs is a corporation with more than one  outlet within a single corporation. If business at one of the locations slows down substantially, that outlet may became a financial drain on the others, absorbing all of the available cash in the company. My approach in these situations is to have each location be separately incorporated or to form a separate LLC to own each location, thus insulating each business from the others. Then, if one were to falter, the liabilities would not drag down the other, still valuable, outlets. A judgment creditor of one LLC  would not be able to reach the assets of the other companies.

This strategy is also useful for a company that manufactures or wholesales different product lines. Companies in the pharmaceutical business face enormous potential liability for many types of drugs and medical devices. The recent oil leak from an offshore well owned by BP has created one of the greatest environmental disasters in history. The company faces tens of billions of dollars in potential liability claims. It’s impossible to say at this point how BP has segregated ownership of other worldwide assets to limit the impact of liability claims, but whatever tactics the company intends to use will be revealed over the coming months and years. Whenever a particular product may be hazardous, using multiple corporations (or other entities) is an effective technique for insulating each separate product from liability caused by another.

Another imperative strategy using separate entities, such as LLCs is to have all operating assets owned by one LLC, and another LLC to own the operating business. The LLC that owns the business assets will then lease them to the LLC that conducts the business. That way the assets are not exposed to the creditors of the operating entity. If a judgment creditor or governmental agency gets a judgement against the operating entity, the operating assets are not subject to that lien or collection by that creditor.

Protecting Corporate Assets From Liability Risks

A critical issue is protecting the assets of the corporation.

The corporation, as an entity operating a business, is in the front line of attack for litigation from every conceivable source.

If the company loses a lawsuit, all of its assets are exposed to creditor collection.

As a result, a crucial asset protection strategy must be adopted for the corporation as well as for the individual.

Remember this rule:  you do not want the business operating corporation to hold any significant assets. You do not want a corporation to build up a substantial net worth only to see everything taken in the event of judgment against the corporation.

Real Estate and Equipment used in the Corporation

Assets, such as real estate and equipment, should never be held by the corporation to the extent they have significant equity.

These assets should be held by another entity-most likely an LLC, or a trust.  Then, those assets should be leased back to the corporation at a reasonable rent. Since the property will be leased, rather than owned, the assets will not be available for collection by a creditor of the corporation unless the asset itself was somehow defective and was a proximate cause of injury, such as under a products liability theory that plaintiffs lawyers make use of. Strategically, additional protection of those assets can be accomplished by what is called ‘equity stripping’ to make the not only not available since they were not owned by the corporation, but with no equity, not attractive to a creditor.

The lease of equipment between the LLC and the operating company, for new equipment the LLC acquires, needs to be properly structured in order to take advantage of the first year personal property expensing tax rules.

Surplus Cash

The corporation should never hold any surplus cash.

Only amounts necessary to pay immediate and foreseeable obligations should remain in the corporate account. Remember this maxim: Cash in, Cash out.

Any surplus should be loaned or paid out as salary or some other type of distribution. The last thing you want is a fat pile of cash available for the taking. Money can be gotten out of a corporation in the form of rents, royalties, dividends, interest, and other forms of fees for use. That is one thing a lease of assets to the corporation accomplishes.

Inventory & Account Receivable

Certain types of property can’t be conveniently held outside of the corporation. Generally, they are inherently a corporate assets because they are sold by the corporation or are the result of sales by the corporation.

Assets, such as inventory and accounts receivable, can cause tax and accounting difficulties, unless they are maintained in corporate form. If these types of assets are significant in value, one solution is to create liens which will have priority over subsequent creditors. For example, the owners of a business or professional practice can make loans to the corporation for working capital or other needs. As security for these advances, the corporation can give the owners, as collateral, a lien on corporate inventory and receivables. This security interest is called a UCC-1 filing under the provisions of the Uniform Commercial Code (UCC). The planned result of this UCC-1 filing is that the inventory and receivables will be protected since they are tied up. A judgment creditor would find that the equity in these assets is subject to the superior claim of the business owners and cannot be used to satisfy the judgment. Another strategy would be to hold inventory in a separate entity, and have that entity fill orders by the operating corporation, in which title to the inventory never changes to the operating entity but is delivered directly by the inventory holding company to the buyer. And, if the inventory company price for the good that is ‘sold’ by the operating corporation, but delivered directly from the inventory company, is substantially the same, the operating corporation would be obligated to pay over virtually all of its sales proceeds to the inventory company. The inventory company should hold a lien through UCC-1 filing in the operating company company accounts receivable, thus rendering them largely unavailable to seizure by creditors.

Intellectual Property

Trademarks, patents, and copyrights are valuable assets which should also not be owned directly by the operating entity. A separate company (generally an LLC) should own these assets and make them available through a form of a licensing agreement in which royalties are paid to that company for their use by the operating company. The objective is to protect these assets in the event of a judgment against the corporation.

Example: Client is in the manufacturing business. Client sells goods to a wholesale customer who sells retail. Wholesale buyer does not pay. The manufacturer is now out of business since it is out of cash and out of credit. The bankruptcy court and the creditors now attempt to seize and sell every asset of the company including any valuable trademark or trade name.

The client engaged in the proper planning before these events took place. The trademark and the trade name were owned by a separate company (LLC). The client then set up a  new company (ABC Corp) then licensed the use of these properties by the separate company  to the corporation on a monthly basis. When the old corporation ultimately filed for bankruptcy (because of the circumstances just described), the trademark and trade name were safely protected in the LLC. Since it was these assets which contained all of the goodwill of the business, the client will be able to successfully go back into business and establish a new operating company.