Timothy F. Rayne, Esquire

One of the major reasons why individuals form corporations to conduct business is to avoid personal liability. The general rule is that a corporation is a legal entity of its own, separate and apart from its owners. As a separate entity, the corporation can enter into contracts, bring legal claims, and be sued.

Usually, the individual owners of a corporation cannot be held legally liable for the debts or bad acts of the corporation. Instead, the corporate form acts as a "veil" protecting the shareholders from liabilities resulting from the operation of the business. There are, however, certain exceptions which can lead to the individual owners being held legally responsible despite "The Corporate Veil."

Participation Theory
The first exception to the rule of "no individual liability for bad acts of the corporation" is the Participation Theory. The Participation Theory states that if an individual actively participates in a wrongful act, he can be held individually liable. For example, if the major shareholder of a corporation also works for the company and, during the course of his duties, is driving a car negligently and hurts someone, both he and the corporation can be held liable. Similarly, if a shareholder intentionally misrepresents facts to a customer to make a sale, both the shareholder and the corporation can be held liable for fraud. An owner who "participates" in bad acts can be held liable despite his attempts to shield himself from liability through the formation of a corporation.

Piercing the Corporate Veil
In addition to the Participation Theory, there is another avenue which creditors or wronged parties can pursue to attempt to force shareholders of corporations to accept individual responsibility. This legal concept is called Piercing the Corporate Veil. This concept allows the normal protection of the corporate form to be disregarded in favor of holding the owners of the corporation legally responsible.

In Pennsylvania, there is a strong presumption against Piercing the Corporate Veil to hold individual owners liable for corporate debts or bad acts. Rather, the general rule is that courts consider a corporation as a separate entity, apart from its individual shareholders, even if the corporation's stock is owned by only one person.

Nevertheless, the courts will allow a corporation's veil to be pierced and will hold an individual shareholder liable when the individual shareholder fails to respect the form of a corporation as a separate entity and instead uses the assets of the corporation as if they are his own.

The courts have looked at several factors to determine whether or not to Pierce the Corporate Veil, including Undercapitalization, Failure to Adhere to Corporate Formalities, and Intermingling of Corporate and Personal Affairs.

Undercapitalization means that the corporation lacks sufficient capital (money) to operate its business. In assessing this factor, the courts often inquire into how much cash was initially invested in the corporation, compared to the potential legal liabilities. For example, if a single shareholder capitalizes with $1000 a general contracting corporation which is expected to build structures worth millions of dollars, that is likely to be considered undercapitalization since the potential liabilities could substantially exceed the initial $1,000 cash investment.

Failure to Adhere to Corporate Formalities addresses the issue of whether a corporate shareholder took all of the required legal steps to organize and operate a valid corporation. This includes having articles of incorporation and corporate bylaws, electing corporate officers, having corporate meetings and keeping minutes of such meetings. If these things are not done, a court is more likely to find that the corporation is a sham and find its dominant shareholder legally liable.

The Substantial Intermingling of Corporate and Individual Affairs factor addresses the issue of whether the shareholders have lived up to their duty to keep corporate and individual affairs separate. Under the law, the corporation and its owners are considered separate legal entities. As separate legal entities, their affairs should be separate.

For example, finances must be kept separate. The corporation should have its own bank account. Monies cannot be simply withdrawn from the corporate account and deposited into the dominant shareholder's account without proper documentation establishing that the payment was wages or dividends. Similarly, the dominant shareholder should not just give money to the corporation without loan papers being prepared. Furthermore, the corporation cannot pay dominant shareholder's bills or debts.

If the financial affairs of a corporation and its dominant shareholder are not kept separate, the court is more likely to disregard the corporate veil and hold the shareholder legally liable.

In summary, the general rule is that when you have a contract with or legal claim against a corporation, you can only sue the corporation, not the individual shareholder of the corporation. However, if you can prove individual participation or that fairness requires Piercing the Corporate Veil, then the individual shareholder, in addition to the corporation, can be sued.

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