A primary focus when starting a business should answer this question: What structure provides the most protection? New founders can get bogged down in the minutia about whether to choose a corporation or a limited liability company (“LLC”), how they want the business to be taxed, or what titles the owners should have. These are all very important decisions, but they can distract from the focus on protecting the owner individually, as well as his or her assets and income. Though choice of entity will dictate tax benefits of the business and the level of protection the owner’s personal assets have from business liabilities, the decision should not stop at the choice of entity and tax classification. The state in which the entity is formed is an equally important decision. Because the LLC is a common entity choice for many founders, here’s a look at some of the protections (and lack thereof in certain circumstances) an LLC provides its owners.
Generally speaking, limited liability means that if the company faces a lawsuit or other financial liability, the owner’s personal assets, such as his or her home, car, or personal bank accounts, are shielded from these claims against the company — instead, only the assets of the business itself are at risk. In other words, courts recognize and respect the separate existence and legal status of the owner and the LLC, and an owner will not be personally liable for contracts, debts, obligations or lawsuits against the business. The LLC’s general liability protection is not absolute, and there are circumstances where a business owner may be held liable for the actions of the LLC and vice versa.
Piercing the Corporate Veil
In certain circumstances, for example, a court may “pierce the corporate veil” and hold the owner personally liable for the company’s debts and obligations. When this happens, courts will disregard the limited liability protection an LLC provides (i.e., the separate legal existence of the LLC and the owner) and the founder can be found liable for company obligations. One of the most common ways that a court can pierce the corporate veil of an LLC is if the owner fails to maintain the required formalities, which are actions that must be taken by an LLC to reflect its legal existence (separate and apart from its owners). For example, if a business owner is operating a construction company, but uses the business bank account to pay his mortgage, buy his groceries, and pay his personal income taxes, a court may decide that his personal assets should not be protected from the creditors of the business, and the business’s assets should not be protected from creditors of the owner in his individual capacity. In essence, because the owner has comingled his own assets with the business’s assets — disregarding their separate legal existence — a court may be willing to allow a creditor to reach beyond (and “pierce” through) the protection an LLC typically offers.
While LLC formalities are not nearly as stringent as those of a corporation, an owner should, among other formalities, keep accurate records, maintain a separate bank account for the LLC, and hold meetings of LLC members and officers at least once per year. Though state laws vary as to what a creditor must prove to pierce the corporate veil, the LLC formalities should be treated as a bare minimum for business owners. Generally, however, courts maintain a firm presumption against piercing the corporate veil, although states such as Delaware, Wyoming, Nevada and South Dakota have stronger presumptions than most.
Charging order protections are a separate but equally important factor that can impact the strength of an LLC’s asset protection. Unlike corporate veil protection, where the owner is protected from being found liable for the obligations of and claims against the LLC (and vice versa), charging order protection shields the business interests from the obligations of and claims against the owner. Typically speaking, when a charging order is enforced, the owner continues to own the LLC interest (with the associated rights of LLC interest ownership), but the creditor obtains a lien against the owner’s distributions from the LLC to pay back the creditor. For example, suppose a small business owner is sued personally by a bank after they foreclose on his home. If his business is his only remaining asset of value, the bank may attempt to collect from the business or foreclose on the business owner’s shares in the business.
Charging order protections will limit a creditor’s ability to collect from a business or foreclose on the owner’s shares. Generally speaking, all states provide charging order protection for LLCs with multiple members (i.e., multiple owners), while only a few provide the same protection for LLCs with a single member (i.e., one owner). The rationale behind this is that one owner of a business should not have their assets put at risk due to the private decisions of another owner of the business. In the case of a single-member LLC, that rationale cannot justify the protection. In fact, only a handful of states provide charging order protection for single-member LLCs: Alaska, Delaware, South Dakota, Nevada and Wyoming.
Finally, in some states, a creditor who successfully obtains a charging order, but is not paid, can have the court order that the owner’s LLC interest be foreclosed upon. Upon foreclosure, the creditor becomes the owner of all of the owner’s financial rights in the LLC interests, including the right to receive distributions from the business. As with above, the creditor will generally not receive any non-economic rights in the LLC (e.g., management rights), so it won’t have the ability to force distributions, but will receive distributions in the ordinary course in accordance with the LLC’s operating agreement. It should be noted, however, that much like charging orders and the varying states’ application of its applicability, certain states expressly preclude foreclosure on LLC interests. Perhaps not surprisingly (and in fact, logically), Alaska, Delaware, South Dakota, Nevada and Wyoming are examples of states that preclude foreclosures on LLC interests.
Furthermore, even in the states that expressly preclude foreclosure on LLC interests, in the event members pledge their LLC interests as collateral in connection with a financing, loan, or similar agreement, the preclusion on foreclosure will not apply. Thus, absent unusual circumstances, a creditor will have the ability to foreclose on the LLC interests pursuant to the members’ express agreement to pledge them as such collateral upon default.
While the remedies described above for a creditor against an LLC interest owner are not exhaustive, it should highlight a pertinent point: Where you form your LLC matters. Every business owner’s plans, circumstances, and facts differ, and some do not place as much importance on asset protection. However, the legal landscape for protecting the owners from business creditors should always be considered at formation. And, though hopefully obvious, it should still be stated: Courts will not look past (including in those friendlier states) fraudulent transfers and conveyances and willful misconduct of an owner seeking to avoid his or her obligations to a creditor. Absent such fraud or misconduct, however, the old maxim holds true: Location, Location, Location!