You may have heard of piercing the corporate veil in the context of for-profit corporations but are you aware that nonprofit corporations can also have their corporate veil pierced?
Corporations provide several advantages for a nonprofit, including favorable tax status, perpetual life, and transferability. The most coveted of these advantages, perhaps, is limited liability.
Generally, corporations provide limited liability protection to their owners. This is known as the “corporate veil”. The corporate veil means that a corporation’s debts are it’s own and that the owners are not personally responsible for the debts and liabilities of the corporation.
Thus, creditors cannot pursue corporate owners’ personal assets to satisfy corporate debts. While nonprofit corporations do not have shares or other ownership interests, the individuals and/or entities controlling them (“Controlling Parties”) enjoy the same benefit of limited liability.
In extreme cases, a court will disregard the separate identity of a corporation to impute liability on its owners and Controlling Parties. This is known as “piercing the corporate veil.” Nonprofits should be aware of this rule because it is possible for a court to pierce the corporate veil of a nonprofit to rectify fraud or injustice.
Piercing the Corporate Veil in Arizona
Piercing the corporate veil in Arizona requires a court to conduct a fact-intensive inquiry into the circumstances of each case. Over the years, Arizona courts have developed certain factors to indicate when it is appropriate to pierce the corporate veil.
Under Arizona law, the plaintiff must prove that:
(a) unity of control exists between the nonprofit corporation and its Controlling Parties; and
(b) if the court upheld the nonprofit’s separate corporate identity, fraud or injustice would result.
First Prong – Unity of Control
The first prong is satisfied when the Controlling Parties enjoy nearly total control over the management and activities of the nonprofit corporation. Arizona courts have identified several factors to which indicate whether total control exists, including whether:
- Controlling Parties finance the nonprofit corporation;
- Controlling Parties pay the expenses of the nonprofit corporation (e.g., salaries, rent, utilities, etc.);
- The Controlling Parties and nonprofit corporation fail to maintain separate corporate formalities (e.g., separate meetings, minutes, books and records, bank accounts, tax returns, etc.);
- The Controlling Parties and nonprofit corporation maintain confusingly similar logos;
- The Controlling Parties fail to convey to third parties the existence of their separate corporate identity; and
- In the event the Controlling Parties include other corporations, the Controlling Parties and nonprofit corporation share common directors and/or officers.
Therefore, to establish a unity of control in Arizona, the Controlling Parties must exercise such a high degree of control over its nonprofit corporation that their separate identities are essentially illusory.
Second Prong – Preventing Fraud or Injustice
Not only must there be a unity of control, but the nonprofit corporation must also have been formed or operated for fraudulent purposes. Examining the facts of each case, the court will determine whether fraud or other injustice would result if it does not pierce the corporate veil.
Because this requires a court to determine the intent of the Controlling Parties and predict future actions, finding that the second prong is satisfied is extremely difficult. Accordingly, it is not common for Arizona courts to find that piercing the corporate veil would prevent fraud or injustice.
Related Post: The Arizona Benefit Corporation
Because so many nonprofits choose to form corporations, it is important for their Controlling Parties to understand their potential legal risks. Although Controlling Parties typically enjoy limited liability from a nonprofit corporation, it is nonetheless possible for nefarious actors to be held accountable.
However, courts are generally extremely reluctant to pierce the corporate veil, and it is very rare for a court to do so. Regardless, prudent Controlling Parties should remain informed of the legal risks of any action they take, including forming a nonprofit corporation.
Kyler Mejia is a third-year law-student with Arizona State University law school and a legal extern with Caritas Law Group, P.C. Caritas Law Group, P.C. advises nonprofit and socially responsible businesses on corporate, tax, and fundraising regulations nationwide as well as donors with regard to major gifts. To schedule a consultation, call 602-456-0071 or email us through our contact form.