The existence of business entities such as corporations and LLCs exist largely to confer limited liability upon the entity’s shareholders or members. This limited liability status encourages entrepreneurs to take risks. It also allows shareholders, particularly minority shareholders, to know that they are generally only risking the money they put into a company.
The general rule in Minnesota is that individuals who have acted in good faith and operated a business entity for legitimate business purposes will not be personally liable for the the liabilities of the corporation.
“Piercing the Corporate Veil”
In some cases, Minnesota courts may allow a plaintiff to overcome the rule of limited liability and hold certain shareholders or agents of the corporation personally liable. This is frequently referred to as “piercing the corporate veil.”
The Minnesota Supreme Court, in Victoria Elevator Co. v. Meriden Grain Co, Inc., created a two-part test for when courts may pierce the corporate veil:
The shareholder(s) treats the corporate entity as a mere “instrumentality” or “alter ego,” AND
A failure to impose personal liability would result in fundamental unfairness.
Part one of this test focuses on the relationship between the corporate entity and the individual, particularly the extent to which the corporation was operated as a separate entity. The Court in Victoria Elevator provided a list of factors that, if sufficiently present, would suggest a disregard for the corporate entity sufficient to satisfy the first part of the test. This widely cited list of factors to consider includes:
insufficient capitalization for purposes of corporate undertaking;
failure to observe corporate formalities;
nonpayment of dividends;
insolvency of debtor corporation at time of transaction in question;
siphoning of funds by dominant shareholder;
non-functioning of other officers and directors;
absence of corporate records; and
existence of corporation as merely a facade for individual dealings.
Not surprisingly, studies suggest it is more common for closely held corporations to fall victim to veil piercing than larger corporations, as closely held corporations are more likely to fail to maintain all the corporate formalities.
Vertical vs. Horizontal Piercing
The concept of corporate piercing may be applied both “vertically” and “horizontally.” Vertical piercing describes instances in which limited liability is cast aside to hold individuals (i.e., officers, directors, or shareholders) personally liable. Horizontal piercing occurs when the courts allow a plaintiff to seek the assets of a parent or sister company. While vertical piercing is more often successful, horizontal piercing is not uncommon. Creating multiple legal entities is of little value if the formalities are not honored.
Avoiding Personal Liability
A shareholder who is aware that the veil of limited liability is not impenetrable can take further steps to limit personal liability, most of which boil down to ensuring the corporation is not being used as a personal vehicle.
Follow the Corporate Formalities
It is easy to want to skip over some of the more annoying requirements of corporate governance, particularly if there are just a few shareholders. But by having annual shareholder meetings, regular meetings of directors and officers, recording minutes, etc., you can help keep your personal assets safe.
Keep the Money Separate
Ensure that there is no commingling of corporate and personal funds. Besides opening yourself up to personal liability to outside creditors, commingling funds can lead to legal problems from other shareholders, as such behavior may breach the legal duties owed to the corporation. Keep separate bank accounts and meticulous records so there can be no doubt of the separation.
While “insufficient capitalization” may often seem blurry, playing it safe will improve your chances of avoiding personal liability. Courts will frown upon a business entity that has $1 million or more in revenue but only $10,000 in capital.