Many entrepreneurs are so focused on getting their business up and going that they do not spend a lot of time thinking about potential liability – they should. Organized or incorporated entities that limit an owner’s liability, which include corporations, limited liability partnerships and limited liability companies organized under Utah laws, are generally considered separate from their individual owners. Legally, they are separate entities. “The purpose of such separation is to insulate the stockholders from the liabilities of the corporation, thus limiting their liability to only the amount that the stockholders voluntarily put at risk.” Salt Lake City Corp. v. James Constructors, Inc., 761 P.2d 42, 46 (Utah Ct.App.1988). While the company and its owners are legally separate entities, there are situations where the entity and the individual owners are considered one in the same. It is the goal of this section to help you, as an entrepreneur, avoid situations where your established entity is disregarded and you are held personally liable.

One of the primary purposes of establishing a corporation or limited liability entity is to remove or at least limit the liability of shareholders (in the case of a corporation), members (in the case of a limited liability company) or limited partners (in the case of a limited liability partnership). The idea of “piercing the corporate veil” allows creditors of the entity to strip the owners of the limited liability protections they sought if the creditor shows that the shareholders in question have utilized the corporation or limited liability entity in a manner that shows that there is a unity of interest between the entity and its owner(s) and the owner(s) have used the entity in a manner that either perpetuates fraud or promotes some form of injustice.

The case of Jones & Trevor Marketing, Inc. v. Lowry, 284 P.3d 630 (Utah 2012) provides guidance on how one can go behind the effectual “veil” created by incorporating or establishing a limited liability entity to hold individual owners personally liable. In the case of such owners, this case provides guidance on how to avoid the pitfalls that will lead to such liability. Lowry is a contract-dispute case wherein one of the parties became insolvent, and the plaintiff tried to pierce the corporate veil of the insolvent company to enable the plaintiff to attach liability to the individual shareholders of the insolvent company. In Utah, the courts will generally follow a two-part test to determine whether the established entity should be disregarded and the individual owners held personally liable.

The Utah Supreme Court established a two-prong method for determining eligibility requirements in order to disregard a stockholder’s limited liability in Norman v. Murray First Thrift & Loan Co., 596 P.2d 1028 (Utah 1979). The Court stated that:

“There must be a concurrence of two circumstances: (1) there must be such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist, viz., the corporation is in fact the alter ego of one or few individuals; and (2) the observance of the corporate form would sanction a fraud, promote injustice, or an inequitable result would follow.”

The Lowry court explained in slightly more detail the two-part test of the alter-ego doctrine that must be satisfied before a creditor can pierce the corporate veil. The two separate portions of the test have been described as the (1) formalities and (2) fairness requirements. The formalities portion of the test refers to the formalities established by state statute governing the entity (whether it is an LLC, partnership

Piercing the Corporate Veil or corporation. An entrepreneur should become familiar with the appropriate statutes or seek the advice of legal counsel to ensure that the appropriate formalities are followed from the creation of the entity forward. The formalities portion of the test can be as simple as going through the appropriate checklist to make sure the requirements are met, so an entrepreneur needs to be aware of what is on that checklist.

The court in Lowry addressed the formalities part of the test when it stated “there must be such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist.” This means that the entity and its owner(s) are one in the same and while the name may be different, there is no legitimate difference between the two. They are operating autonomously.

The second part of the test that must be reviewed is whether “the observance of the corporate form would sanction a fraud, promote injustice, or an inequitable result would follow.” This means that because the entity and the owner(s) are operating as one, if the court allows the owner(s) to hide behind such a façade then the outcome would either be illegal or unfair. The two-part test associated with the alter ego doctrine is somewhat amorphous and thankfully the courts have provided some additional direction on factors that may be considered in determining whether one can pierce the corporate veil or alternatively whether one can avoid having the corporate veil pierced.

The other considerations discussed in the Lowry case come from a case entitled Colman v. Colman, 743 P.2d 782, 786 (Utah Ct.App.1987). The factors were discussed as useful considerations, so there is not a set formula in determining what weight if any to give the eight factors, but they are useful to provide additional guidance. The factors are as follows:

undercapitalization of a one-man corporation; (2) failure to observe corporate formalities; (3) nonpayment of dividends;
siphoning of corporate funds by the dominant stockholder;
nonfunctioning of other officers or directors; (6) absence of corporate records; (7) the use of the corporation as a facade for operations of the dominant stockholder or stockholders; and
(8) the use of the corporate entity in promoting injustice or fraud.

The court in Lowry was very clear that these factors were useful to consider, but stressed that the analysis is a very fact specific analysis. The analysis must happen in each different case because no one factor is determinative, and none of the eight factors are actually required elements that must be proven to prevail. It is conceivable that in certain circumstances only one of the factors may be met and the court could still allow the creditor to pierce the corporate veil. The determination will rely heavily on the relationship between the owner(s) and the entity. In Dockstader v. Walker, 510 P.2d 526, 528 (Utah 1973), the Utah Supreme Court laid out some concerns to be aware of in situations where an entrepreneur is the sole owner and is operating the business as

a shell entity when it stated:

The doctrine [of corporate disregard] generally applies to situations known as ‘one-man corporations,’ i.e., where one man owns practically all of the stock either directly or through others who hold it for his use and benefit, and where the stockholder uses the corporation as a shield to protect him from debts or wrongdoings. It cannot be applied to make a stockholder liable for the legitimate debts of a corporation unless he is so closely allied with the corporation through ownership and management as to enable the courts to see clearly that the corporation is but a sham and it is the stockholder who is doing business behind the corporate shield.

Entrepreneurs should be especially cautious in following the appropriate formalities when they will be the sole owner of the company. Because single-member entities or one-man corporations are typically run by that individual as well, the formalities need to be strictly followed because the courts may view the fairness factors more skeptically where the company and the individual have been operating as one in the same.

Fraudulent Transfers

Entrepreneurs need to be aware of situations where transfers they make can be undone if those transfers are made fraudulently. If an entrepreneur makes a transfer that harms the rights or the company’s creditors, then there is the possibility that a court could come in and ignore the transaction as a void transaction. It will be as if the transaction did not occur, or the court could allow liability to pass to a new entity if the individual sets up a new entity to avoid paying creditors. In both of those situations, the transactions are voidable because improperly trying to escape from company creditors will be viewed as potential fraud and may allow creditors to attach to successor entities.

One factor that is important to consider when looking at transactions is whether the transaction is commercially reasonable. A commercially reasonable transaction is one that appears to be an arms-length transaction that is not unfairly giving preference or favoring one party to the detriment of the other. For example, if a company has creditors and feels that it is in the company’s interest to sell a large asset of the company. It may sell the asset and likely avoid allegations of fraud if the asset is sold to a third- party for a fair market price. The reason this is not fraudulent is because the asset was replaced with another asset (in the form of cash) that is still owned by the company. Alternatively, if a company sold its primary asset to one of the owners of the company for something less than market value, then that transaction looks like a fraudulent transfer and is more likely to be challenged by creditors. The creditors in the second-scenario would likely argue that the self-dealing transaction should be voided to allow the company to retain the value of the asset and thereby provide a greater likelihood of the creditors being paid.

“The law has long held that transfers of property designed to place a debtor’s assets beyond the reach of the debtor’s creditors are void as to the creditors.” National Loan Investors, L.P. v. Givens, 952 P.2d 1067, 1069 (Utah 1998). If an entrepreneur attempts to transfer company assets to avoid paying these debts, then there is a high likelihood that such a transfer could be challenged and unwound.

There are also several situations where an entrepreneur should be wary of involvement in transactions where their company could be held liable as a successor. Pursuant to Macris & Associates v. Neways, Inc., successor liability is defined as the moment “where one company sells or otherwise transfers all its assets to another company.” In addition, this case specifies that the purchaser of a company will be held liable for prior debts if:

The purchaser [of the company] expressly or impliedly agrees to assume such debts; the transaction amounts to a consolidation or merger of the seller and purchaser; the purchasing corporation is merely a continuation of the selling corporation; or the transaction is entered into [by the seller and purchaser] fraudulently in order to escape liability for such debts.

As outlined in the above example, successor liability occurs when a new owner/purchaser of a corporate entity takes on the previous debts of the entity he/she purchased. Successor liability applies to those who dissolve previous companies as a means of either avoiding liability for debts or, for those who see fit to expand at the expense of a prior entity. Why is this significant? Often, when a purchaser wishes to avoid payment on debts, he/she is involved with a fraudulent conveyance or transfer.

Utah follows the Restatement (Third) of Torts § 12, which allows for successor liability in four cases:

(1) where the successor agrees to assume the liability of the predecessor; (2) where the transaction was a fraudulent conveyance designed to escape liability for the debts or liabilities of the predecessor; (3) where the transaction is a consolidation or merger with the predecessor; or (4) where the transaction results in the successor becoming a continuation of the predecessor.

See Herrod v. Metal Power Prods. (Utah 2008); see also Macris & Assocs., Inc. v. Neways, Inc., 1999 UT App 230, ¶ 15, 986 P.2d 748,

752, aff’d, 2000 UT 93, 16 P.3d 1214. We will briefly analyze each of these situations to assist the entrepreneur in avaoiding situations of potentially significant liability. In the first situation, the case suggests that the successor entity would have to actually agree to assume the debt. If you do not intend to accept liability, then do not expressly agree to assume the liability and do not impliedly assume the liability. Careful drafting of asset purchase agreements can be key to avoiding liability.

It can often be important to have an understanding of who you are doing business with, and that is the idea behind the second situation described above. If the entity with whom you enter into a transaction is entering into the transaction to avoid liability on prior debts or liabilities, then the transaction will need to be analyzed as we previously discussed to determine whether it meets the indicia of a fraudulent conveyance. If it appears fraudulent, then the transaction could be voided or the successor entity may be liable to the prior creditors.

The third successor liability situation arises where there is a merger or consolidation. If the original entity will continue to exist, then you have to understand that everything that entity brings with it, the good and the bad, will come with it. Even if the merged company has a new name, the new entity does not escape liability if liability previously existed in the prior entity.

The fourth situation involving successor liability is likely the most legally and factually complex of the four situations. In situations where there was a prior debt or other liability that existed in a given entity, if the owners of that entity leave and start a new entity doing the same or similar business, then the law provides a way for the creditors of the prior entity to go after the new entity as a “successor” to the previous entity.

The takeaway for fraudulent conveyance and successor liability situations is (1) to properly protect yourself and understand the ramifications of the contracts into which you enter; (2) if a legitimate debt is incurred, then properly address the debt and do not try to simply avoid the liability by shifting or transferring assets; and (3) recognize that where legitimate debt or liability has been incurred, trying to start a new business, either through a new establishment, merger, or consolidation, where the business is doing the same thing may not protect you from previously incurred liability.