Alter Ego Theory

Under the alter ego theory, the creditor seeking to pierce the veil of limited liability must prove that the owner did not operate his limited liability company (LLC) or corporation as if it were a separate legal entity.

It is this "separateness" that forms the basis for limited liability. Ordinarily, the LLC and corporation are recognized as separate legal entities, and each is responsible for its own debts. The owner, as a separate person, has no personal liability for the business entity's debts.

Accordingly, as long as the owner respects this separateness, the business entity will continue to be recognized as a separate entity, and the business entity itself (and not the owner, who is a separate person) will be responsible for the business's debts. The most the owner can lose will be what has been invested into the business entity. In other words, the owner will have limited liability for the business's debts.

Conversely, if this separateness is not apparent in the way the business owner operates the LLC or corporation, there is no basis for limited liability. In short, if the owner acts as if the LLC or corporation is not a separate legal entity, but instead just another side of the owner (i.e., his alter ego), the court may rule that the owner and the entity are one and the same. Thus, the owner will, out of necessity, have unlimited, personal liability for all of the business's debts.

In general, avoiding the alter ego theory means operating the business entities in ways that steer clear of the factual patterns wherein courts have applied the theory. As suggested throughout this discussion on asset protection, the owner should form an LLC or statutory close corporation, and then must separate and document ownership of assets.

Further, the formalities regarding division of authority within the entity, required meetings and recordkeeping must be observed.

Finally, the owner must separate his or her financial affairs from the entity's financial affairs, as well as separating the financial affairs among all operating entities.