Avoiding The Imposition Of Personal Liability For Corporations

Post Authored by Brian Bentrup

The limited liability rule is firmly established in Illinois. It means that individuals are not personally liable for the debts of a corporation or a limited liability company (“LLC”). Piercing the corporate veil is a concept that applies to corporations and LLCs in Illinois. Specifically, it imposes personal liability against owners, members, and managers of LLCs. For corporations, it applies to directors, officers, and shareholders for the corporation’s debts if certain criteria are met. While many assume their personal assets are protected, that premise is only true if appropriate corporate formalities are strictly followed.

Piercing the Veil of a Corporation

In Illinois, piercing the veil to hold a shareholder personally liable for corporate debts is an equitable doctrine that courts invoke reluctantly, with caution, and only after the creditor has met a “substantial burden.”[1] Two principal requirements must be met in order to pierce the corporate veil:

• there must be such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist; and
• circumstances must exist such that adherence to the fiction of a separate corporate existence would sanction a fraud, promote injustice, or promote inequitable consequences.[2]

Unity of interest and ownership is a key phrase that examines the degree of separation between the entity owners and the entity itself. Illinois courts have found the following factors dispositive of the “unity of interest and ownership” prong:

• inadequate capitalization;
• failure to issue stock;
• failure to observe corporate formalities;
• nonpayment of dividends
• insolvency of the debtor entity;
• nonfunctioning of other officers or directors;
• absence of corporate records;
• commingling of funds;
• diversion of assets from the entity by or to a member to the detriment of creditors;
• failure to maintain arm’s-length relationships among related entities; and
• whether, in fact, the entity is a mere facade for the operation of the dominant members.[3]

Illinois courts have focused their analysis on (1) the failure to maintain adequate corporate records or to comply with corporate formalities, (2) commingling of funds or assets, (3) undercapitalization, and (4) one corporation treating the assets of another corporation as its own.

Illinois courts have also singled out undercapitalization, or the insufficiency of capital contributions by shareholders, as a factor whose presence weighs heavily in favor of piercing.[4] Insolvency, the inability to pay debts, is a similar concept but is not considered undercapitalization. It also does not automatically result in piercing the corporate veil. Undercapitalization, particularly at the corporation’s inception, means the corporation and individual should not be classified as distinct entities. It creates an inference that the entity deliberately or recklessly created a business that would not be able to pay its debts.

The failure to follow corporate formalities and a parent company’s use of subsidiary funds are related concepts that can easily be avoided. Illinois courts have long held that the failure to follow corporate procedure may lead to the individual liability of a shareholder, director, or officer. Even a non-shareholder—who is not an officer, director, or employee of a corporation—may be found individually liable for a judgment against a corporation where the non-shareholder exercises only equitable ownership and control over a corporation; the non-shareholder is liable even if there were no allegations that the non-shareholder engaged in any wrongdoing.[5]  Strict adherence to the corporate form will proactively avoid these common problems.

Practically speaking, almost all LLCs and corporations satisfy the first prong, because both are artificially-created entities and individual ownership and interest are often aligned.

In order to satisfy the second prong, there must be a connection between the abuses of the corporate form and the alleged fraud or injustice. The difficulty lies in determining the type and degree of conduct rising to the level of injustice sufficient to warrant piercing the protection provided by the entity form.

Other than instances of fraud, injustice sufficient to impose personal liability falls into three categories: (1) when shareholders deplete the corporation’s assets when it is insolvent, at risk of becoming insolvent, or after depletion, would become insolvent; (2) when shareholders misrepresent the corporation’s financials in order to induce a creditor into extending credit; and (3) when the corporate form is manipulated to evade a statutory duty or common law obligation or to defeat or circumvent the law.[6] Knowing this at the entity’s inception will help avoid common pitfalls during the entity’s operation.

The rationale for limited liability in Illinois is predicated on the fact that a corporation and its shareholders are intended to be legally distinct entities. But, when a corporation is merely the alter ego of its single shareholder or few majority shareholders, the two entities are no longer legally distinct and results in unity of interest and ownership.[7] Unity of interest and ownership may be satisfied even when the individual is a non-shareholder or lacks a corporate title. The result is that an individual may be held jointly and severally liable.

[1] Kelsey Axle & Brake Div. v Presco Plastics, Inc., 187 Ill App 3d 393, 543 NE2d 239, 243 (1989).

[2] In re Estate of Wallen, 262 Ill. App. 3d 61, 68–69, 633 N.E.2d 1350, 1357 (1994).

[3] Fontana v. TLD Builders, Inc., 362 Ill. App. 3d 491, 500 (2005).

[4] Id.

[5] John Buckley and Mama Grimm’s Bakery, Inc. v. Haithham Abuzir, 2014 IL App (1st) 130469 (April 10, 2014).

[6] Mark W. Page, The Undercapitalized Corporation and Illinois Corporate Veil-Piercing Law, Ill. St. B. Ass’n (July 2000), www.isba.org/ibj/2000/07/theundercapitalizedcorporationandil.

[7] Id.