Contractors routinely face a number of liability threats as a cost of doing business. One that is occasionally overlooked is the threat of "alter ego" liability. Are you the alter ego of your company? And what does that mean exactly? Under the law of most states, it means that you could be held personally liable for the debts or liabilities of your corporation or limited liability company if a plaintiff is able to satisfy certain legal requirements. Most likely, your intent in setting up a separate corporation or LLC was to avoid that kind of responsibility. It pays, therefore, to know a bit about the law of alter ego liability.
Under California law, alter ego liability will be imposed where two conditions are met: (1) there is such a unity of interest and ownership that the separateness of the individual (or another entity) and the business entity has ceased; and (2) recognizing the business entity as being separate from the individual (or other entity) would, under the particular circumstances, "sanction a fraud or promote injustice."
The meaning of the above standard is subject to considerable judicial interpretation and, as is often the case in litigation, the courts assess a variety of factors in deciding whether to impose liability on an alleged alter ego. The factors are numerous and the case law is not always consistent. Moreover, alter ego liability can be imposed where some of the factors, but not others, are present. Nonetheless, most alter ego cases have at their core an allegation that the defendant has failed to maintain proper separation between his or her personal affairs (or the affairs of another owned business entity) and those of the company being sued.
Here are a few simple guidelines for contractors and other business owners (including members of a California limited liability company) seeking to avoid the prospect of a personal judgment for the obligations of a corporation or LLC:
- Observe all corporate formalities. Devote the necessary time and attention to this task. It will be well worth it in the long run.
- Never commingle assets (or liabilities). Maintain separate bank accounts and keep them separate. Always avoid commingling the funds of separate corporations or LLC's, and always keep personal and corporate funds separate from corporate funds. Never pay the debts of one using an account maintained by the other. (Contractors in California should also be aware of the potential civil and criminal penalties for diverting funds from one job to another-which is a topic for another update.)
- Never use corporate funds to purchase services or items for personal use. Pay yourself first, then use your own personal funds for your purchases.
- Never hold yourself out as being responsible for the debts or obligations of your company.
- Have adequate capitalization for your intended operations and purchase adequate insurance.
Following the basic guidelines above will not protect you from an alter ego judgment in all circumstances; every case is unique and calls for individualized legal advice and attention. If you have questions about avoiding alter ego liability, or if you are sued as an alleged alter ego, seek prompt legal advice.