Hello everybody. From time to time, apartment owners take title to their property in the name of a corporation in which they are the sole shareholders. Typically, that is done for two reasons: (1) asset protection and (2) tax benefits.
My discussion this month will focus on asset protection (or lack thereof) and leave taxation matters to the accountants.
The goal of asset protection is to shield the individual owners from personal liability in the event that a judgment is awarded against the corporate entity, such as by a tenant who sues for unlawful discrimination or wrongful termination. For example, if sizable damages are awarded by a jury in favor of a tenant against the corporation for wrongful acts, typically, only the assets of the corporation, and not the assets of the individual shareholders of the entity, will be liable for damages.
The theory is that since corporations are legal entities which have their own separate existence from that of its principals, a debt (such as a jury verdict or a court judgment) against the company should not become the debt of its owners.
But there are two important exceptions, or at least qualifications, to that concept. Accordingly, owners who contemplate forming a corporation for the purpose of insulating themselves from personal liability to a tenant or others should bear the following in mind.
Individual Liability from Wrongful Acts
Shareholders of a corporation are not liable for the debts of the entity merely because they own the corporation. Nevertheless, the individual shareholders who commit the wrongful acts or omissions are personally liable for their own negligence independently of the liability of the entity.
For example: If one or more shareholders are responsible for actively managing an apartment building but fail to implement reasonable measures to prevent the recurrence of foreseeable sexual assaults against tenants on property (such as by replacing burnt out light bulbs to ward off predators or repairing broken entrance security locks), those individual shareholders, in addition to the corporation, will be personally liable to the tenant.
In other words, the managing shareholders are not liable because they are stockholders in the corporation. Instead, they would be liable because they negligently managed the building in such a manner that it was foreseeable that a tenant would be injured. In that case, liability is predicated on wrongful individual conduct, not on mere ownership of the corporation.
As an aside, individual members of an LLC who negligently manage a building would have the same type of liability to a tenant or others as would corporate shareholders who negligently manage a building.
Piercing the Corporate Veil
Ordinarily, shareholders who are not negligent in their management are not personally liable for a corporate debt merely because they are the owners of the company.
But there is a major exception to that generalization by which liability is imposed against a non-negligent shareholder under a legal principle known as “Alter Ego.”
Historically, we humans have gone to great lengths to shield ourselves from harm from others. In Merry Old England, the Crown protected its land with the aid of its knights, who themselves were clothed in suits of armor to protect their own selves from the swords of their attackers.
In today’s world, a tenant’s weaponry against a landowner is typically litigation. To protect against potential future judgments, individual principals may form a corporation to own the property and issue themselves shares of stock. The shareholders’ individual protection against a judgment would be the corporation. Thus, the corporation is the shareholders’ shield against a judgment.
If there were no corporation (or other type of entity), the individual owners would be personally liable for the amount of the judgment.
Still, shareholders of a corporation (whether or not negligent) may be personally liable by a theory of Alter Ego if certain procedures are not followed. That liability is imposed by “piercing the corporate veil.”
In Baize v. Eastridge Companies (142 C.A.4th 293), the California Court of Appeal explained that a corporation’s separate nature as an independent entity may be disregarded under the Alter Ego doctrine and its corporate veil pierced if two general conditions are met: (1) That there is such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist, and (2) That if the acts were treated as those of the corporation alone, an inequitable result would follow.
The court held that when “the separateness of the corporation is abused, it will be disregarded and the corporation looked at as a collection or association of individuals, so that the … stockholders will be liable for acts done in the name of the corporation.”
What follows is a list of situations which shareholders should avoid to best preserve the corporate protection and avoid Alter Ego. The more items that exist below, the more likely it is that a court will find that the corporate shield should be pierced and the underlying owners held personally liable:
- Money and assets of the corporation are commingled with those of the individual shareholders.
- The shareholders fail to segregate their own funds from those of the corporation.
- The shareholders fail to adequately capitalize the corporation when it is formed such that the corporation may not be able to meet its anticipated debts. (Note: The advice of a good accountant would be helpful to determine the adequacy of capitalization.)
- The corporation fails to issue stock to the individuals.
- The corporation fails to hold annual meetings of the Shareholders and Board of Directors and fails to maintain corporate records and minutes.
- The individual shareholder holds himself out as being personally liable for the debts of the corporation, such as when he contracts with a roofer in his own name to construct a new roof or he leases a laundry room in his own name to a laundry company.
- The corporation is used as a mere shell or instrumentality for a single venture or business of the individual.
- The corporation disregards various legal formalities and fails to maintain an arms-length relationship among related entities or individuals.
- There exists a diversion or manipulation of assets from the corporation to a shareholder or other person to the detriment of creditors.
- The corporation is formed with the intent to avoid performance by the corporate entity or the corporation is formed for purposes of carrying on illegal transactions.
- The shareholder withdraws rents deposited into the corporate account without regard to the fact that the rents belong to the entity, rather than to the individual.
- The shareholder frequently deposits his/her own funds into the corporate account so as not to bounce checks or so as to render the corporation financially solvent to pay its debts.
- The shareholder uses a single address for the individual and the corporation.
- The shareholder acts in bad faith.
Because the doctrine of Alter Ego is based on principles of equity, the court will evaluate each case separately to ascertain which, if any, of the above elements exist, and whether, because of the apparent unity of interest and ownership between the entity and the owners, an inequitable result would occur if the entity’s shield is not pierced.
As is evident, the use of a corporation to hold title to multifamily residential property is not necessarily the panacea of protection that the principals of the entity may expect. For AOA members who form a corporation to acquire or hold title to their buildings, I encourage you to carefully consider and avoid the 14 items listed above so as to enhance the probability that your corporation’s legal separation will be preserved.
Finally, one of the best protections for the underlying owners of entities to avoid personal liability is to hire an independent management company to operate the property. By so doing, the owners distance the corporation as well as themselves from personal management, and in turn, from liability due to any negligent or otherwise wrongful operation of the building.
Dale Alberstone is a prominent real estate attorney who has specialized in real property and resident manager law for the past 40+ years. He also serves as a mediator of real estate disputes and is a former arbitrator for the American Arbitration Association.
Mr. Alberstone has been awarded a 5 Star AV rating from Martindale-Hubbell. That is the highest possible rating and reflects an attorney who has reached the heights of professional excellence and is recognized for the highest levels of skill and integrity.
The foregoing article was authored May 2020. It is intended as a general overview of California law only and may not apply to the reader’s particular case. Readers are cautioned to consult a lawyer of their own selection with respect to any particular situation.
Questions of a general nature are warmly invited. Address correspondence to Dale S. Alberstone, Esq., ALBERSTONE & ALBERSTONE, 269 S. Beverly Drive, Suite 1670; Beverly Hills, California 90212. Phone: (310) 277-7300.