Limited Liability Companies are a popular structure for a business. Like a corporation, an LLC can provide a degree of liability protection, but with less paperwork. But depending on how you structure and operate your business, the amount of liability protection it offers may be open to question.
In the event of a lawsuit, a judge can decide to set aside your LLC’s liability protection and determine that you and your business partners are indeed liable for its business debts. How can that happen, and how can you protect yourself?
IS YOUR LLC REALLY PROTECTING YOU?
Typically you create a business entity to separate your personal assets from the assets and monetary flows of the business. You want to protect your personal assets in the event of debt incurred during the operation of the business.
As a rule, LLC members are only exposed to company debt in the amount of their capital contribution into the LLC. But when there’s not enough money in the LLC account to pay debts, creditors may ask the court to set aside the LLC’s liability protection and come after its members’ personal assets. This is referred to as “piercing the veil.”
Piercing the veil can only happen through litigation. Someone must sue your business and allege that you are simply using it to hide behind. If successful, a business creditor may be able to claim your home or spousal income. How does this happen, and how can you prevent it?
WHEN DO COURTS PIERCE THE VEIL?
When deciding if they should pierce the veil, courts will rely on two main legal principles – “under-capitalization” and “Alter Ego.” Here are some of the things they’ll look at.
- Was the LLC adequately capitalized at its founding?
- Have the disbursements to members stripped the business of money with which to pay debts?
- Has the company acted recklessly in applying for credit with no plan to pay back the debt?
- Is there fraud anywhere in loan applications?
- Do the owners treat the company money as their personal funds?
- Do they use personal accounts for business payments (or vice versa)?
- Do they keep accurate records?
- Do they record minutes of meetings, and resolutions of important decisions?
- Is the LLC current with all filings required by the state?
There is no one standard to apply in these cases across all the states. All courts will examine the “totality of factors” to decide what has been going on with the business.
WHO IS AT RISK?
The small business is most at risk from this kind of scrutiny, because the small business owner tends to disregard many of the formalities of operating a legal entity as a business. In fact, the small LLC, whether single-member or family owned, is most commonly sued for debt recovery using the legal principles for piercing the veil of protection.
Another risk example is a start-up company of young entrepreneurs with great ideas and skills but no money. This is the typical “bootstrap” company that can easily overreach or underfund, and end in dissolution seeking bankruptcy, with outstanding debts.
As a third example, some people form an LLC as part of an asset protection plan. If they manage a particular asset – a rental property, say – with too close or careless a personal involvement, they may be reducing their liability protection in the event of a claim against the property.
HOW TO PROTECT YOURSELF
There’s no point creating an LLC either as a single member or with other entrepreneurs, only to be stripped of liability protection, and essentially be returned to a sole proprietorship or general partnership. When the veil is pierced by a court, even if the cause has been created by one member, every member and all personal assets are potentially in danger.
- So it’s important to follow these guidelines to keep your liability protection strongness world, be diligent about the letter of the law.
- Keep the proper company records. State clearly in the LLC Operating Agreement when the members hold meetings (if ever), and comply with this. A single-member LLC operating agreement should clearly state no meetings. But all LLCs should record the minutes of meetings that are held, and also record all resolutions and important decisions.
- Keep all the records in one place. An LLC Records Kit is widely available to purchase, and is a useful way to record the resolutions, minutes, salaries and disbursements, etc., of the company.
- Make sure you contribute adequate funds into the LLC when you create it. Adequate means reasonably sufficient to operate the business. This amount can be reduced over time as revenues come in. The court will look at the initial amount to decide if there was a fraudulent intent in creating the company.
- Similarly, avoid reckless behavior such as applying for credit that you have no realistic plan in place to pay back.
- Don’t take so much money out of the company that you don’t have any reserves to pay operating costs.
- Don’t make false claims or lie when applying for credit for your company.
- Don’t commingle funds or assets.
- Don’t personally guarantee payment of credit extended to your company.
- Don’t deposit company receipts in your personal account.
- Don’t use company checks for personal expenses.
- Separate mixed usages.
- With mixed-use assets, such as a vehicle used for business and personal, keep a log of usage.
- Use formal reimbursement for personal assets and expenses used in business. Create a written agreement that spells out this usage and refer to it with reimbursements.
- Always act as a company in all your advertising, letters, invoices, and all communications. Use the logo and letterhead to the full. To prove you’ve been acting as a company, you must be seen to.
- Don’t sign company checks without adding your company position to show that you represent the company.
- Don’t use old stationery or branded materials, bank accounts, etc. from an earlier company. This creates a form of commingling. Create everything new to match the new business entity when you create it.
This should probably be Rule #1: don’t try to close the business with a creditor holding outstanding debt. Nobody likes bankruptcy, but be aware that leaving a vendor or a landlord with an “unjust cost” is a principle that can cause a court to pierce the veil. If your company is facing dissolution, consider professional advice for the safest way to proceed.
One additional protection you can take for yourself is insurance. It can cost as little as a few hundred dollars per year to insure yourself against errors and omissions, and personal liability. If you’re a member of an LLC with other members, consider what liability another member might expose you to. Educating the other members into responsible behavior may fall to you. You may also look into asset-protection planning, to shield your personal assets if the LLC falls into danger.
It’s really not difficult or burdensome to comply with these business requirements – they’ve been established over centuries by lawsuits against bankrupt companies! It creates a mindset of caution and public responsibility as you operate your business. And it shows a paper trail of diligence which will help show you as a legitimate business entity in the event of claims against you. Good luck!
Stan Huser is the founder of SunDoc Filings, a Sacramento-based company that helps entrepreneurs form LLCs or incorporate in California or any U.S. state. A pioneer in document filing and retrieval, Stan started his first company in 1979.