Piercing the LLC Veil

 By Robert J. Mintz, J.D., LL.M (taxation)

Some recent court cases have allowed creditors of an LLC to pierce the LLC veil making the LLC members personally liable for the company’s obligations. The effect of these cases is to reverse the legal protections which allow investors and business owners to limit their personal liability to the amount invested in a venture. One example of current trends in LLC veil piercing is Martin v. Freeman (2012 COA 21. No. 11CA0145), discussed in the note at the end of this article.

Many physicians use Limited Liability Companies to hold investment assets such as equipment and real estate or to operate a business outside of their practice. LLC’s are generally easier to form than corporations, have fewer formal operating requirements and offer a greater variety of tax planning options.

Limiting Personal Liability

Most importantly for some, the basic tenet of LLC law is that members and managers of the LLC are not personally liable for the debts of the company. This is known in legal terms as limited liability and it prevents a creditor of an LLC (or a corporation) from pursuing the personal assets of an owner. The problem is that the purported protection of the LLC law is often and increasingly disregarded by the courts under a variety of legal theories leaving personal assets exposed and unprotected from business risks – exactly the result that the owner was attempting to avoid.  In this month’s article we’ll address the reasons why the courts are reaching these surprising conclusions and what steps can individuals take to protect themselves from unexpected and possibly significant financial losses.

This limitation on liability is a crucial factor in operating or investing in a business venture. An investor wants certainty that personal assets, not invested in the business, are free from any potential claims which might arise. The concept of limited liability permits an individual to calculate the extent of the financial risk which is being assumed in relation to potential profits from the business. If a particular project involves a fixed investment of $100,000 then the risk and potential returns can be estimated and a rational decision about the value of the investment is possible.  Limitations on personal liability are a foundation of any market economy because no individual or company would knowingly make an investment if the total cost of the investment, including potential liabilities, could not be reasonably calculated in advance.

For example, suppose that the initial $100,000 amount invested in the business was not limited in any manner and instead the total amount of the investors net worth – everything that the investor owned – was subject to a future claim of the business?  That proposition is difficult or impossible to evaluate because in this case, the amount of the investment and potential liabilities cannot be accurately measured in advance and the value of the investment is uncertain.  Individuals are justifiably reluctant to make investments which place all of their personal assets at risk and the typical solution is to use an LLC or corporation which is intended to limit this exposure.

Piercing the Corporate Veil

Corporate Formalities

The ability of a lawsuit plaintiff to reach the personal assets of the business owner is known as piercing the corporate veil. Prior to the widespread adoption of LLC legislation in all states in the early 1990’s, corporations were the most widely used form of business entity. But corporations had some glaring defects in accomplishing this essential mission of limiting personal liability. Most notably, over the years, courts tended to weaken the corporate liability shield under a variety of legal theories.  Thousands of cases on these issues have been decided and broad rights have developed for those seeking to “pierce the corporate veil” and hold the owners personally liable.

One legal ground for piercing is failure to follow corporate formalities.  For example, corporations have certain legal formalities which must be adhered to, such as issuing shares, holding annual meetings, preparing minutes, and creating and maintaining governing bylaws. In cases where these formalities are not properly followed, courts have held that the legal liability protection of the shareholders was effectively waived and the personal assets of the owners could be reached by the plaintiff. This result is most likely to occur in smaller, family owned businesses, which tend to be less diligent in maintaining the corporate records than larger companies with the resources and staff necessary to meet filing and compliance requirements.

Alter Ego

A second rational for piercing the corporation veil is based on what is known as alter ego liability.  What this means is that when an individual and a company are so closely linked that they should not be viewed as separate entities for legal purposes, the shield against personal liability will not be applied.

Over the years, courts have enumerated dozens of factors that should be considered in making this determination.  Some of those examples mentioned frequently in the cases include: (1) commingling of funds and other assets, (2) the treatment by an individual of the assets of the corporation as his own, (3) the failure to maintain minutes or adequate corporate records, (4) the use of the same office or business location, employment of the same employees and/or attorney, (5) the failure to adequately capitalize a corporation, and (6) the use of a corporation for a single venture,

In making the determination under the alter ego test, the law is that no single factor is determinative, and instead a court must examine all the circumstances to determine whether to apply the doctrine.  In reality, what this means is that in almost any situation, a finding of alter ego liability can be made depending on the outcome that the court would like to produce. There are very few circumstances under which at least one or more of the dozens of factors have not been violated at some point. Small businesses sometimes treat corporate formalities, written minutes and banking in a more casual manner than larger companies with staff and resources. Since there are so many factors which can be considered and the proper weight to be given to any particular factor is left entirely to the courts discretion, it is too often the case that if a court wishes to find alter ego liability, it is easy enough to do so. A reading of the cases demonstrates that similar fact patterns produce dramatically different results based on the particular conclusion which the court is attempting to shape. The outcome depends less on the conduct of the parties than it does on the courts view of what a just or fair result should be.

Piercing the LLC Veil

What we have described above about piercing the corporate veil applies as well to Limited Liability Companies. LLC law in the states, as expressed in the legislation and court cases generally, permits piercing of the LLC veil to the same extent as corporate law. Although LLC formalities are sometimes not as strict as those of corporations, when the alter ego doctrine is asserted, a failure to hold annual meetings and maintain adequate company records may influence the court’s decision on personal liability protection.

One of the unfortunate byproducts of the uncertainty surrounding the application of the law is an inevitable increase in the number of cases filed against LLCs and their owners.  In fact, merely filing these cases, without much regard to merit, may be a profitable business strategy in itself. Lawyers and lawsuit plaintiffs take advantage of the unpredictable outcome of any case by routinely naming the owner as a defendant in litigation against the LLC.  This move immediately places the owner’s personal assets in jeopardy since he or she is threatened with potentially large legal costs as well as a real loss of personal assets if the plaintiff is successful. Depending on the size of the claim and the amount of the defendant’s available wealth, plaintiffs and their lawyers know that there is usually strong motivation for the owner to settle to avoid litigation costs as well as the possibility of an unfavorable outcome in the case,  When a legal outcome is  uncertain, as it is in most veil piercing cases,  plaintiffs lawyers working on a contingent fee have significant bargaining leverage over an LLC owner who must bear the costs of defending the litigation and the possibility of large personal losses.

How to Protect against Personal Liability

The first step to avoiding personal liability in these cases is to comply with the legal requirements concerning company formalities and operations as described in the cases and legislation. This certainly means that the initial organizational filings, IRS compliance and operating documents and procedures for the company are correct and properly maintained. The company should be adequately capitalized for its purpose and commingling of accounts, and undocumented contributions and distributions should be avoided.  Following these legal requirements won’t guarantee success, but depending on the facts of your case, may help tilt the scales toward avoiding personal liability.

As an additional safety measure, many business owners use asset protection planning to insulate and shield personal assets from the risk that their LLC or corporation will be pierced. This legal planning generally involves the use of strategies such as retirement plans, trusts and holding companies to protect assets such as homes, savings and investments. A full description of the asset protection techniques and planning used by physicians can be found at “Legal Guide to Asset Protection Planning.”

Taking the proper steps to minimize the risks of business makes sense for those who have accumulated savings and investments.  If these assets are intended to be held separately and apart from the liabilities of your business activities then some planning to accomplish this result should be considered. As a note of caution, make sure to discuss the details of your particular matters with your advisors to make sure that the tax and ramifications of your planning strategies are properly evaluated and are appropriate for your specific situation.

Note:

One example of current trends in LLC veil piercing is Martin v. Freeman (2012 COA 21. No. 11CA0145).

To pierce the LLC veil, the general rule is similar to that applied to corporations. The court must find (1) the LLC entity is an alter ego or mere instrumentality; (2) the LLC form was used to perpetrate a fraud or defeat a rightful claim; and (3) an equitable result would be achieved by disregarding the LLC form.

“Courts consider a variety of factors in determining alter ego status, including whether (1) the entity is operated as a distinct business entity; (2) funds and assets are commingled; (3) adequate corporate records are maintained; (4) the nature and form of the entity’s ownership and control facilitate insider misuse; (5) the business is thinly capitalized; (6) the entity is used as a mere shell; (7) legal formalities are disregarded; and (8) entity funds or assets are used for non-entity purposes”

In concluding that the LLC was the defendant’s alter ego, the court found:

• Tradewinds assets were commingled with Freeman’s personal assets and the assets of one of his other entities, Aircraft Storage LLC;
• Tradewinds maintained negligible corporate records;
• The records concerning Tradewinds’ substantive transactions were inadequate;
• The fact that a single individual served as the entity’s sole member and manager facilitated misuse;
• The entity was thinly capitalized;
• Undocumented infusions of cash were required to pay all of Tradewinds’ operating expenses, including its litigation expenses;
• Tradewinds was never operated as an active business;
• Legal formalities were disregarded;
• Freeman paid Tradewinds’ debts without characterizing the transactions.
• Tradewinds’ assets, including the airplane, were used for non-entity purposes in that the plane was used by Aircraft Storage LLC without agreement or compensation.
• Tradewinds was operated as a mere assetless shell, and the proceeds of the sale of its only significant asset, the airplane, were diverted from the entity to Freeman’s personal account.

Based on these factors (all fairly common for LLC operations) the court addressed the question of whether the LLC had been used to perpetrate a fraud or defeat a rightful claim. Perhaps, most disturbingly, the court found that since LLC protection would bar the plaintiff from collection, that fact itself satisfied the requirement that the LLC be used to defeat a legitimate claim. No proof of fraudulent intent was necessary.

“We conclude that showing that the corporate form was used to defeat a creditor’s rightful claim is sufficient and further proof of wrongful intent or bad faith is not required.” (Colorado Court of Appeals – LLC Veil Piercing)

As discussed above, LLC’s were enacted by all state legislatures specifically to place limitations on personal liability-a crucial factor in all investment and business decisions. Sensible investors evaluate an investment by comparing the maximum loss against the potential rewards. LLC’s, as well as corporations, were intended to limit an investor’s risk to the amount of capital invested in a project. When the corporate or LLC veil can be pierced based upon court determined standards of “fairness” and “equity” the risk-reward calculation of an investments value is skewed. What if a $100,000 investment in a project can produce a $1 million personal liability if the entity veil is pierced by a court?  Is it still a good deal? Strategies to protect accumulated personal assets from corporate or LLC veil piercing are becoming standard practice in business planning.

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