Liability exposure is a common concern of both for-profit and tax-exempt entities. To minimize liability risk, parent entities create subsidiaries to engage in activities that would otherwise expose the parent to liability. In the tax-exempt context a parent may incorporate a subsidiary to operate a specific charitable program, such as a residential facility for the disabled, a thrift store, or a school. This structure is advantageous to the parent because only the assets of the subsidiary would be at risk for the liabilities of the charitable program. Tax-exempt entities with limited resources may be dissuaded from creating subsidiaries due to the misconception that the parent must operate entirely independent of the subsidiary. While certain functions must be separate, the law allows considerable overlap without compromising the liability shield provided by separate corporate personalities.
It is important to note, however, that if a parent and subsidiary exceed this limit, the assets of the parent could be subject to the subsidiary’s liabilities. This is known as “piercing the corporate veil.” Under Illinois law, to pierce the corporate veil two elements must be present: (1) the unity of interest between the two entities is such that that the separate personalities of the entities no longer exist and (2) the circumstances are such that adhering to the fiction of a separate corporate existence would promote injustice or inequitable consequences.
Illinois case law provides significant guidance on the “unity of interest” element, which seems to be the most-heavily discussed element in opinions that address veil-piercing. Illinois courts analyze several factors to determine if the “unity of interest” element has been satisfied. The following factors will usually be relevant to for-profit and tax-exempt organizations: (1) inadequate capitalization; (2) failure to observe corporate formalities; (3) insolvency of the debtor corporation or diversion of its assets to the detriment of creditors; (4) nonfunctioning of the other officers or directors; (5) the absence of corporate records; (6) commingling of funds; and (7) the failure to maintain arm’s-length relationships among related entities. In the case of for-profit entities, courts may additionally consider the failure to issue stock, nonpayment of dividends, and whether one entity is a mere façade for the operation of dominant stockholders.
Provided that the parent-subsidiary relationship does not exhibit any of the above factors Illinois courts will not likely pierce the corporate veil. This allows parent and subsidiary entities to collaborate extensively without each entity being responsible for the liabilities of the other. For example, Illinois courts allow a parent and subsidiary corporation to share common employees, officers, and directors without invoking the veil-piercing doctrine. It is also permissible for the parent to exercise oversight of a subsidiary corporation, such as by naming the subsidiary’s directors. The parent may even be involved in the day-to-day operations of the subsidiary. In one case, the parent provided billing, accounting, and personnel services for the subsidiary. In another case the subsidiary’s use of the parent’s trademark was not a sufficient basis to invoke veil-piercing.
Courts do not provide much guidance on the second factor of the analysis, use of the corporate existence to promote injustice or inequitable consequences. However, courts describe this element as requiring an element of unfairness, like fraud or deception, or another compelling public interest. Examples of conduct that satisfy this standard include use of the corporate form to evade payment of indebtedness, to obfuscate so that a statute of limitations expires, to conceal the identity of the correct defendant, or to wrongfully obtain credit. Generally, the second factor encompasses use of separate legal entities for anything other than legitimate business purposes.
Establishing a subsidiary can often be a good strategy for an exempt organization to limit its liability exposure for certain charitable programs. The law allows entities to collaborate closely and share resources, while preserving liability protection. As a caveat, organizations may need to be selective about which functions they share in order to prevent direct liability. For example, sharing an employee with a subsidiary could cause the parent to be liable for torts committed by the employee while working for the subsidiary. Therefore, organizations should carefully structure the parent-subsidiary relationship to maximum liability protection. David L. Bea & Associates can help your organization with these matters.
The attorneys of David L. Bea & Associates are experienced in corporate law. If you have any questions, please do not hesitate to contact us.
The foregoing article was provided for general information and must not be relied upon as legal advice for any specific situation.
© 2011 David L. Bea & Associates