Your Business, Your LLC, Your Baby–Properly Managing an LLC to Avoid Losing your Liability Protection

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[author: Kaiser Wahab, kwahab@wrlawfirm.com]

So you want to start your own business and can’t decide whether you want to open a corporation, limited liability company (LLC), sole proprietorship, or partnership? Somewhere in the back of your mind – most likely an imprint of your recent and avid lectures of glossy magazines articles catering to entrepreneurs such as yourself – you read or heard about the incredibly advantageous and flexible LLC format. But do you understand the concept of limited liability and to what extent does the term “limited” extend to cover your business activities?

There is much literature praising the benefits of LLCs as a new business form for the small to medium-size business owner. LLCs are indeed an advantageous business model because, unlike corporations, profits and losses can pass directly through to the owner’s personal income tax return while the owner’s personal assets are shielded from liability. But this protection is not unlimited, and if the owners of an LLC do not take adequate precautions, they can find themselves facing a potential lawsuit without the benefit of having their personal assets protected from a judgment against the LLC.

Under the long-standing doctrine of “piercing the corporate veil,” corporate shareholders have become intimately familiar with the prospect of having their assets subject to an adverse judgment if a court deems that the corporate form has been disregarded by its officers and directors. Courts are now applying the same doctrine to LLCs in what could be named the “piercing the LLC veil” doctrine. So what does this doctrine stand for and how do you protect your state’s grant of limited liability?

The principle underlying the doctrine is that no business entity should rely and utilize the entity’s financial shelters as a tool to defraud or perpetuate a wrong against an outside entity. In other words, you can run but you can’t hide your assets behind your LLC’s name. To “pierce” an LLC veil requires a showing that: (1) the owners (i.e. you) exercised complete domination of the LLC with respect to the subject transaction; and (2) that such domination was used to commit a fraud or injustice which resulted in an injury to an outside party. In order to determine whether an LLC is “dominated” by its owners, courts will consider a number of factors, including:

• Disregard of LLC formalities: although not as burdensome as the corporate form, the LLC remains an entity that is regulated by its owners and such, it requires that its owners follow the formalities set out in the LLC’s operating agreement.

• Inadequate capitalization: one of the most important factor that may ultimately determine a court’s decision to pierce the LLC’s veil. All business entities, including LLCs, should have sufficient capital to run the entity’s business properly. Veil piercing will most likely occur in instances where the owners siphoned out the assets of the LLC, leaving too little in the corporation to satisfy creditors. However, grossly undercapitalized LLCs may also have their veils pierced where additional factors, such as disregard of formalities or intermingling of funds, are present.

• Intermingling of funds: also a crucial factor. Owners should never – ever – intermingle their personal funds with that of the LLC; separate bank accounts should always remain separate.

• Overlap in ownership, officers, directors and personnel: to the extent possible, owners should not overlap their roles and titles in the LLC.

• Common office space, address and telephone numbers of the business entity and owner: the more the LCC exhibits independence from its owners, the better. It is important to note the commonality factor is not determinative of the issue but merely a factor that should be examined in determining whether the LLC is a separate and distinct business entity from its owners. To do otherwise would essentially dispose of home operations.

• The amount of discretion showed by the allegedly dominated LLC: decisions made by the LLC should be in the LLC’s best interest, as opposed to its owners’ personal agendas.

• Whether the LLC is treated as an independent profit center: similarly as above, the LLC should be a working business as opposed to an extended personal account of its owners.

• Whether others pay or guarantee debts of the dominated LLC: owners should not pay or guarantee the debts of their own LLC.

• Intermingling of property between the alleged dominator and the LLC: similarly as above, absolutely no intermingling of funds or property permitted.

Although none of these factors are dispositive on the issue of domination, a court may find that the presence of any combination of such factors leads to the conclusion that the business entity was disregarded and manipulated for the mere benefit of its owners. If that is the case, an LLC may find itself facing an adverse judgment with no limited liability protection against the owners’ personal assets.

To illustrate the doctrine, let us examine a few examples.

Example 1:

Christopher enters into an investment agreement with WeInvest LLC, of which Cassandra is the sole member. Under the agreement, WeInvest LLC establishes an investment scheme, thirty days of duration, in which Christopher is to recover its investment capital plus forty to fifty percent.

Cassandra, as the sole member of the LLC, keeps the LLC inadequately capitalized. Cassandra issues loans to the LLC from her personal accounts in order to keep the LLC in business. Cassandra also uses the LLC’s funds for her personal expenses such as personal trips and parking expenses. Cassandra takes a mortgage on her home in order to pay for the LLC’s business expenses; proceeds of the loan go into Cassandra’s personal bank account.

Christopher provides WeInvest LLC $400,000 in accordance with the agreement. Christopher never receives back his principal nor any profits from his investment.

Under this scenario, Christopher will most likely succeed in piercing the LLC’s veil to recover his investment from Cassandra’s personal assets.

Example 2:

Bob is the only member of WeDeliver LLC, a local package delivery service. WeDeliver LLC’s balance sheet shows a net worth of $50,000. Unexpectedly, Better Delivery Corp. opens its doors next to WeDeliver LLC which causes the market for WeDeliver LLC’s services to dwindle. WeDeliver LLC’s net worth drops sharply, Bob is unwilling to add additional capital, and the company soon goes out of business.

Peter, who lives in the same city in which WeDeliver LLC does business, is hit by WeDeliver LLC’s truck while jogging. Peter brings a suit to pierce the LLC veil of WeDeliver LLC.

Under this scenario, Peter may be able to pierce WeDeliver LLC’s veil in order to reach Bob’s personal assets.

The application of the doctrine, whether in the LLC or corporate setting, is considered a drastic remedy by most courts, particularly in instances where the owner is an individual as opposed to another business entity. Accordingly, a court will only in rare circumstances, and after much deliberation, resort to this remedy. It is also important to note that it is perfectly legal to form an LLC to avoid personal liability, what is illegal is using this financial shelter to the detriment of another.

So what can you do to protect your company’s limited liability? Keep your affairs organized to the utmost degree. Make sure that you separate your personal affairs from your LLC: keep separate bank accounts; pay your business expenses from your LLC’s account; do not infuse the LLC account with personal funds; do not use LLC funds for personal expenses. Set a percentage ownership for each owner and distribute profits accordingly, or draw an annual salary for each owner of the LLC. If you have employees, implement a policy whereby each employee is responsible for making sure that the LLC is run properly.

Sounds like a lot of work? Remember, forming a business entity is a financially creative enterprise, a child of your entrepreneurial aspirations. It is a living being recognized under law that must not be ignored or abused. So be kind and patient to your creations, as they may surpass your own expectations in the long run, and such rewards are priceless.