How Business Owners Become Liable for Corporate Debts: Recent Iowa Court of Appeals Case Provides a Refresher on Veil-Piercing

On February 7, 2018, the Iowa Court of Appeals refused to pierce the corporate veil of a small family business in Laddie Nachazel Family Living Trust v. JKLM, Inc.[1] “Piercing the corporate veil” is a legal term used to describe a court’s decision to disregard the limited liability shield provided by a business entity, such as a corporation or LLC, and hold the individual shareholders accountable for corporate debts. Courts do so because they have found the corporate entity is a mere shell, serving no legitimate business purpose, that is being used to promote injustice.

For small business owners, this is the worst-case scenario. You incorporated your business to shield your family from corporate liability, but now your corporate creditors are lining up for access to your personal bank accounts. How did you get here? Iowa courts consider the following factors in determining whether to disregard a business’s limited liability shield:

1. Whether the corporation is undercapitalized;

2. Separation of the corporate books;

3. Separation of corporate and individual finances, and whether individual obligations are paid by the corporation;

4. Whether the corporation is used to promote fraud or illegality;

5. Adherence to corporate formalities; and

6. Whether the corporation is a mere sham

In the Nachazel case, the court was tasked with determining whether to pierce the corporate veil of JKLM, Inc., an Iowa corporation created to borrow money and own a pizza joint. Creating a corporation for property ownership is common business practice. JKLM had $3,000 in assets at the time of the purchase and had to borrow $12,000 to come up with the $15,000 down payment for the $120,000 pizza joint. The $12,000 was borrowed from a related entity.

JKLM did not keep records of annual meetings, adopt bylaws, or issue stock, though it formally ratified several years of past corporate actions after the suit was initiated. Corporate actions were taken via written consent as opposed holding formal meetings. JKLM’s lease for the pizza joint was oral. An owner’s daughter borrowed approximately $17,000 from JKLM during its existence. Notwithstanding, JKLM kept separate corporate books from its owners, had separate bank accounts, filed separate tax returns, and paid payroll taxes.

Considering the factors above, the Iowa Court of Appeals upheld the district court’s decision not to pierce JKLM’s veil and hold the owners personally liable for the purchase price of the pizza joint. Here’s how JKLM performed during the six-factor test:

The good: The court found the separate bank accounts, payments, and tax returns demonstrated that corporate/personal funds were not comingled. The loans to the owner’s daughter had the legitimate business purpose of reducing payroll expenses and were not improper. No fraud or injustice was shown. The entity was created for the legitimate business purpose of owning the pizza joint.

The bad: While the question of corporate formalities was a close call, the court did not find corporate formalities completely lacking. It did note, however, that a corporation cannot simply ratify corporate actions after a suit has been filed in hopes of creating a formal corporate trail and avoiding liability.

The ugly: The court found that JKLM was undercapitalized – it had four times as much debt as capital prior to the pizza purchase, and forty times as much debt as capital after.

The six-factor test is not pass/fail, so JKLM’s poor performance on the capitalization prong was not fatal. Thought JKLM’s veil remains intact, this case provides valuable reminders for Iowa corporations and LLCs:

1. Always maintain a corporate bank account separate from your personal bank accounts and pay bills accordingly;

2. If you own multiple businesses, keep a separate bank account for each;

3. Observe corporate formalities by maintaining a stock (or ownership) ledger, annually electing officers, and approving or ratifying significant corporate events, even if those actions are conducted via written consent as opposed to in-person meetings;

4. Utilize written contracts for corporate transactions as often as practical, especially where the corporation is doing business with a related entity, shareholder, director, officer, or their family members; and

5. Sign corporate contracts in your capacity as a corporate officer, not personally (John Doe, President).

While not an exhaustive list, these “rules of the road” are critical for maintaining your business’s limited liability shield and protecting your personal assets. For questions on small business operations, contact attorney Laura Wasson.

The material in this blog is not intended, nor should it be construed or relied upon, as legal advice. Please consult with an attorney if specific legal information is needed. 

- Laura Wasson