Even when a business has created a limited liability company or a corporation in an effort to decrease or eliminate personal liability of shareholders and partners, those shareholder or partners can still be considered personally liable under a theory called “piercing the corporate veil.” Piercing the corporate veil is an equitable remedy and usually arises when a contract or tort creditor of a corporation wants to reach the personal assets of a shareholder. Courts apply a two-prong test to determine whether a claimant can pierce the corporate veil. The two prong test comes from the case of Victoria Elevator Co. v. Meriden Grain Co., 282 N.W.2d 509 (Minn. 1979). In order to pierce the corporate veil both prongs of the test must be met.
The first prong of the test is whether the shareholder established the corporation sufficiently as a separate entity or whether the corporation was formed as the shareholders “alter ego” or “mere instrumentality.” The following factors are relevant to the first prong of the Victoria Elevator test:
- Insufficient capitalization for purposes of the corporate undertaking;
- Failure to observe corporate formalities;
- Non-payment of dividends;
- Insolvency of the debt or corporation at the time of the transaction in question;
- Siphoning of funds by the dominant shareholder;
- Non-functioning of the other officers and directors;
- Absence of corporate records; and
- Existence of the corporation as merely a façade for individual dealings.
The court has found that not every single one of these factors has to be present to find that the first prong of the test has been met. If several of the factors are relevant then the first prong is satisfied.
Avoiding Injustice or Unfairness
The second prong of the Victoria Elevator test looks at the relationship between the person suing the corporation, and the corporation. The second prong also looks at whether the piercing of the corporate veil is necessary to avoid injustice or fundamental unfairness. Under the second prong the court must find that the failure to impose personal liability would be an injustice or would be fundamentally unfair and the corporation has been operated in such an unjust manner with respects to the plaintiff as to require relief. It is not always clear what is considered injustice or fundamental unfairness. Further, and interestingly, the court said in Victoria Elevator that satisfaction of the first prong may satisfy the second prong. In that case the court implied that simply using a corporation in a manner described as a factor under the first prong could sufficiently satisfy the second prong. Thus, that piercing the corporate veil would be necessary to avoid injustice.
While the plaintiff who is attempting to pierce the corporate veil does not have to provide proof of common law fraud, there must be some evidence that the corporate entity was operated in an unjust or unfair manner. To avoid any allegations or attempts to pierce the corporate veil, a business owner should maintain procedures that will help preserve the safe guard of the limited liability shield. Some examples of these procedures would be regular shareholder meetings, separate corporate accounts, and ensuring to not comingle any personal finances with the finances of the corporation.