How to avoid piercing the corporate veil between parent corporations and their subsidiaries

The doctrine applies equally to individual shareholders and to corporations that own other corporations (e.g., parents and subsidiaries). And, in fact, corporations of all sizes use the parent-subsidiary structure to expand their operations and invest in new ventures. Because the subsidiaries have their own existence, they are responsible for their own debts and liabilities, and their parents‘ risk is limited to their investment.

However, under certain circumstances, a court may disregard the subsidiary’s separate existence and treat the parent and subsidiary as one. When a court does this, it’s called piercing the corporate veil.

Standards applied in piercing the corporate veil cases

Courts are aware of the importance of the separate existence of corporations and shareholders and are therefore reluctant to pierce the corporate veil. However, they will disregard a subsidiary’s existence to hold the parent responsible for the subsidiary’s debts and liabilities when a failure to disregard would bring about an inequitable result.

Courts across the country use somewhat different standards in determining whether to pierce. But, in general, a court will pierce the corporate veil where the parent so controlled and dominated the subsidiary, and their affairs were so intermingled, that fairness dictates that the acts of the subsidiary be considered the acts of the parent. This is often referred to as the subsidiary being an “alter ego” of the parent. Most courts also require that there be an element of injustice and unfairness in addition to domination and control.

Five alter ego doctrine factors

An analysis into piercing the corporate veil is very fact intensive. There are a number of factors the courts look at in determining whether the subsidiary is merely an alter ego of the parent. No one factor is determinative, and in most cases, it takes a combination of factors being present before a court will find that the subsidiary is the parent’s alter ego.

Although the factors can vary from court to court, they generally include the following:

1. Whether the subsidiary was adequately capitalized when formed and solvent enough to pay its anticipated debts when conducting business. Undercapitalization and insolvency are factors that indicate an alter-ego relationship.
   
   
2. Whether the subsidiary had functioning officers and directors. Some overlap of management between the parent and subsidiary can be expected. Therefore, the test is whether the subsidiary’s officers have the power to run the business independently. In particular, the courts look at whether the parent makes decisions that ordinarily would be made by the subsidiary, such as the hiring and firing of employees.
   
   
3. Whether the subsidiary observed corporate formalities. Here, the courts look at whether the subsidiary held duly noticed director and shareholder meetings, kept minutes and other books and records, issued stock, had bylaws, etc. The courts also look at whether the subsidiary complied with the provisions of its governing corporation law — such as by filing annual reports, paying franchise taxes, and maintaining a registered agent and registered office.
   
   
4. Whether the parent’s assets and subsidiary’s assets were kept separate. The test here is whether the parent treated the subsidiary’s cash, property, and other assets as if they were the parents. Commingling of assets is frequently cited by courts as evidence of an alter-ego situation.
   
   
5. Whether the parent held the subsidiary out as being a part of it, rather than a separate corporation. Here, the courts consider representations made by the parent about the subsidiary (particularly to the plaintiff) and other factors such as whether they had the same office address, telephone number, email address, and employees.

Elements of unfairness or inequity

Evidence of domination and control is typically not enough for a court to pierce a subsidiary’s corporate veil. Courts also look for a wrongful or unjust act that injured the plaintiff. And the fact that the subsidiary could not pay the plaintiff’s debt is not enough. Something more is required — such as if the parent intentionally siphoned the subsidiary’s funds in order to prevent it from paying the debt, or the parent formed the subsidiary to engage in the wrongful act that injured the plaintiff, or the parent directed the subsidiary to take the action that caused the loss to the plaintiff.

Avoid having a court pierce the corporate veil

Just as there is no one factor that will cause a court to pierce the corporate veil, there is no one action a parent corporation can take to ensure the court will not pierce the corporate veil.

However, if the parent and its subsidiaries take the following actions, it can help mitigate the risk of a court piercing.

1. Make sure subsidiaries are adequately capitalized when formed and to the extent possible, remain solvent.
   
   
2. The subsidiary’s management should be responsible for its day-to-day operations. They should not have to obtain the parent’s approval before making decisions in the ordinary course of business.
   
   
3. The subsidiary should observe corporate formalities and comply with the requirements of the governing corporation statute.
   
   
4. The subsidiary’s assets should be kept separate from the parents. The subsidiary should have its own bank account and its own books and records.
   
   
5. Document inter-company transactions. If the parent loans money to the subsidiary, or vice versa, it should be recorded on the books as a loan. Transactions between the parent and subsidiary should be negotiated at arm’s length, and the terms should be fair to both corporations.