Opinion ID: 1364715
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Heading: Undercapitalization and Continuing Loans

Text: The O'Hazzas contributed $10,000 in initial capital to the corporation, and subsequently loaned the corporation approximately $140,000 over a two-year period. The trial court specifically found that the corporation was undercapitalized and that the corporation would have failed almost immediately without the loans from the O'Hazzas. Initial capitalization of a corporation can be an indicator of whether a corporation was created and operated as a sham or as the alter ego for another corporation or person. If, from its inception, a corporation is unable to pay its costs of doing business because of grossly inadequate capitalization, its legitimacy is suspect. Under such circumstances, stockholders may not be entitled to the corporate shield. Fletcher § 44.1. Thus, the court in In re County Green Ltd. Partnership, 438 F.Supp. 701 (W.D.Va.1977), held that initial capitalization of $100, accompanied by a situation in which the controlling shareholder drained the corporation's earnings and increased the corporation's financial dependency, were factors used to justify a decision to pierce the corporate veil. Id. at 706. In the instant case, ECC produced no evidence to show what an appropriate level of capitalization would have been for a business that installed sound equipment. Consequently, a determination that $10,000 was insufficient initial capitalization is questionable, particularly in light of the $9,412 profit shown on the corporation's federal tax return for 1987, its first year of operation. We note also that, to gain certain tax advantages, small corporations increasingly, and legitimately, choose to initially capitalize the entity with a small portion of the investment represented by stock and with the larger portion of capital set up as loans to the corporation. If the corporation fails, these loans are subordinated to those of other creditors. Fletcher § 44.1. And, as pointed out by the O'Hazzas, federal courts, in distinguishing between corporate debt and risk capital, have considered a loan made to a corporation by stockholders without expectation of repayment as an indication that the transaction involved venture capital, not a true loan. See e.g., Liflans Corp. v. United States, 182 Ct.Cl. 825, 390 F.2d 965 (1968); Cuyuna Realty Co. v. United States, 180 Ct.Cl. 879, 382 F.2d 298, 301 (1967); P.M. Finance Corp. v. Commissioner, 302 F.2d 786 (3d Cir. 1962). Finally, we never have recognized loaning money to a business that is sustaining losses as a ground for piercing the corporate veil. In Garrett v. Ancarrow Marine, Inc., 211 Va. 755, 180 S.E.2d 668 (1971), creditors of a closely held corporation were unsuccessful in their attempt to pierce the corporate veil and enforce a mechanic's lien against the property of the corporation's stockholders, even though the corporation was insolvent and able to continue in business only because of substantial loans made by the stockholders. Id. at 756, 180 S.E.2d at 669. We find that the trial court clearly erred in finding that the corporation was undercapitalized and in relying on this finding and the fact of the subsequent loans by the O'Hazzas to the corporation as grounds for piercing the corporate veil.