If you are a small business owner, chances are you operate your business through a separate entity, such as the popular limited liability company. Indeed, the protection of limited liability is one of the main reasons business owners go to the trouble of forming and maintaining a separate entity.
A lawsuit in Nashville that made local business news headlines last month, D’Affari Properties, LLC vs. Martin Heflin et. al., Chancery Court for Davidson County, Tennessee, No 13-1118-I, involves a judgment creditor’s attempt to pierce the veil of an LLC to hold the members personally liable for the judgment. This likely caused many business owners to contemplate the prospect of being personally liable for business judgments, debts or other obligations.
Business owners who operate through a legal business entity are generally protected from personal liability for company debts, business decisions or actions of the company. In Tennessee, there is a presumption that a business entity is a distinct legal entity. This means the entity is wholly separate and apart from its shareholders, members, managers, officers, directors, subsidiaries, or affiliate companies. The Tennessee Business Corporation Act provides “[a] shareholder of a corporation is not personally liable for the acts or debts of the corporation except that the shareholder may become personally liable by reason of the shareholder’s own acts or conduct.” Tenn. Code Ann. § 48-16-203(b). Likewise, members, owners, employees or other agents of a Tennessee limited liability company generally have no personal liability for the debts or obligations of the company. Tenn. Code Ann. § 48-217-101(a)(1); Tenn. Code Ann. § 48-249-114(a)(1)(B).
However, courts in Tennessee, under certain circumstances, will disregard the company as a separate entity upon a showing that it is a sham or as “necessary to accomplish justice.” This is commonly referred to as “piercing the corporate veil.” Piercing the corporate veil is ordinarily to get at the assets of the shareholders/owners individually or the parent of a subsidiary corporation.
While some courts in Tennessee have cautioned that the veil should be pierced only in “extreme circumstances”, the courts have adopted the following factors in determining whether to pierce the corporate veil:
Factors to be considered in determining whether to disregard the corporate veil include not only whether the entity has been used to work a fraud or injustice in contravention of public policy, but also: (1) whether there was a failure to collect paid in capital; (2) whether the corporation was grossly undercapitalized; (3) the nonissuance of stock certificates; (4) the sole ownership of stock by one individual; (5) the use of the same office or business location; (6) the employment of the same employees or attorneys; (7) the use of the corporation as an instrumentality or business conduit for an individual or another corporation; (8) the diversion of corporate assets by or to a stockholder or other entity to the detriment of creditors, or the manipulation of assets and liabilities in another; (9) the use of the corporation as a subterfuge in illegal transactions; (10) the formation and use of the corporation to transfer to it the existing liability of another person or entity; and (11) the failure to maintain arms length relationships among related entities.
Courts will typically rely upon a combination of the Allen factors in deciding whether to pierce the corporate veil. Recent cases demonstrate that courts are more likely to pierce the corporate veil when the corporation is being used to wrongfully divert money to avoid a judgment or other monetary obligation. The Tennessee Court of Appeals has considered the inability to demonstrate a lawful justification for a diversion of funds from one corporation to another as proof of corporate abuses sufficient to justify piercing the corporate veil and holding shareholders personally liable on the debts of the corporation.
At the same time, the courts have emphasized that the question of when an individual should be held liable for corporate obligations is largely a factual one and each case must rest upon its special facts. This, of course, makes it impossible to define a bright line rule. However, in order to avoid an action to pierce the corporate veil, it is certainly wise for business owners to avoid running afoul of the Allen factors.
Should you have questions regarding a veil piercing issue, please contact the Thompson Burton PLLC business litigation and dispute resolution team.