Undercapitalization Theory

Besides application of the alter ego theory, there is another way a creditor can pierce the veil of limited liability.

The undercapitalization theory requires that the creditor prove the business owner intentionally underfunded the entity when it was initially organized to defraud the business's creditors.

Because an owner's liability for the business's entity's debts is limited to the investment in the entity, the business owner should invest as little vulnerable capital as possible within the business form (as suggested in our discussion of funding the business by using operating and holding companies).

Further, this strategy will continue to be effective only if there also is in place a plan to withdraw vulnerable funds as they are generated by the business entity.

These strategies may seem incompatible with the undercapitalization theory. However, with proper planning, the small business owner can minimize his investment of vulnerable capital within the business form and avoid the application of this theory.

Specifically, to avoid the undercapitalization theory, the business owner should avoid doing anything that might result in application of the alter ego theory and focus on the initial capitalization of the operating entities.