Is LLC Liability Really Limited? - Piercing the Corporate Veil
Limited Liability Companies are everywhere these days – and for good reason – but what does it mean to say liability is limited? There are a number of instances where the limited liability ‘corporate veil’ is pierced and personal liability can be involved. In cases where the corporate veil is not pierced, you still have potentially unlimited corporate liability. This can involve complicated insurance matters and areas of corporate bankruptcy law. Other than that, in a general case and depending on State law, the owners of the company would expect to only be potentially held liable up to their funds at risk in the particular venture. In other words, liability is not unlimited even when you own a Limited Liability Company. Is that false advertising? Not necessarily.
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What is Limited Liability?
Limited liability means that the LLC or corporate entity is a separate and distinct entity that exists completely apart from its owners. Whatever funds, assets or property that is held by LLC is generally at risk – but that’s it. If the corporation is held liable for something, all of the business’ assets, funds and property could be used to satisfy that liability. Where this does not usually extend is beyond what is owned by the business itself and into the personal assets of the owners themselves. It’s important to know, however, that this separation between the LLC as an entity and the owners of the LLC also doesn’t necessarily always apply.
Many entrepreneurs create business entities to operate their businesses, in part because some entities, such as Limited Liability Companies, do shield the owners from personal liability – in general. This is because, legally, the business is considered separate and distinct from the owners. It is important to know, however, that Limited Liability Company structures are not always going to avoid personal liability for the owners in every case.
The Corporate Veil
Maybe of you have heard of the term “piercing the corporate veil?” Piercing the corporate veil is a term of art that describes situations where the limited liability of the corporation will not protect the owners of the business for some reason. In such cases, legal action would be permitted against a company and would ultimately lead to personal liability of the owners, shareholders, or members because the corporate structure is disregarded for some reason by a Court. In veil piercing cases, owners’ bank accounts, real and personal property interests, and investments may be at risk.
Most veil piercing scenarios are based entirely on State law. This is particular true in the context of LLCs which are created by state law in the first place. Instead of going into the details of every possible state, here’s some general scenarios where limited liability may not be so limited.
1. The existence of fraud, wrongdoing, or injustice to third parties.
There’s going to be some major factors that a Court will look for in cases where liability might not be limited. Among those factors, by far the most egregious is fraud, wrongdoing, or injustice. In a majority of cases, someone is asking the Court to pierce the corporate veil and order the owner of the entity to pay out of their personal assets for some liability due to extraordinary wrongdoing of the company or its owners.
Here’s an example. Corporation A receives a final judgment for money damages against Corporation B. Corporation B cannot pay the judgment and, as a result, is forced to shut down. Just prior to shutting down, Corporation B transfers all of its assets to Corporation C and Corporation C continues on to operate essentially the same business as Corporation B. Corporation C uses the same assets, whatever funds were left when they were transferred and is basically the same business. This is a prime example of wrongful fraudulent actions where the corporate formality may be ignored. Sure, the entities are different and should theoretically have limited liability. That means that Corporation C should not be liable for the debts of Corporation B. However, shutting down its business and essentially reopening a new corporation that is no different in principle would not provide limited liability. The key would be the defrauding of a creditor.
Wrongful conduct such as a transfer to defraud creditors could even lead to a shareholder’s personal liability for torts of the corporation. If a creditor goes through the process of obtaining a judgment against the corporation only to later learn that the corporation had transferred all of its assets, post-judgment, to other corporations controlled by the corporation’s primary shareholder, limited liability probably will not apply. If the Court finds that the transfer was made in order to hinder, delay, or defraud the original judgment creditor, it can be expected that the corporation will have its veil pierced and its shareholders could still be found liable for the underlying judgment.
The overarching point here is that every transaction, particularly where there is evidence of fraud or wrongdoing, is going to be viewed from an objective perspective. If you are involved in a questionable business transaction such as described above, you should consult with corporate legal counsel to guide you through your options.
2. Failure to maintain the separate identities of parent and subsidiary companies.
One example where liability is not so limited is less scandalous than fraud or wrongdoing but can have just as serious implications. A lot of businesses and individuals own or operate several related affiliates or multiple companies acting under the umbrella of one company. The failure to maintain distinct, clear and separate identities of the companies is a major pitfall that can lead to veil piercing.
To illustrate this point, consider an example. Corporate A is a parent company of Corporation B, its subsidiary company. Corporate A operates and controls Corporate B, provides the capital for the Corporate B, indicates the same officers, address, and corporate information, and files consolidated taxes with Corporation B. With so much overlap, Corporation B is at risk of being seen as a “mere alter ego” of Corporation A. In such cases, a court may pierce the corporate veil to pursue the personal liability of corporate officers (especially since they are the same for both companies). Among the factors involved in this type of analysis, the court would analyze the following to show that Corporation B was merely an instrumentality or alter ego of Corporation A:
(1) the same person controlled both the parent and subsidiary;
(2) they operated out of the same facilities as the parent;
(3) the subsidiary’s contracts were performed by employees of the parent;
(4) the subsidiary was never capitalized; and
(5) the subsidiary shared bank accounts and financial obligations with the parent.
In some jurisdictions, the court may also require a showing of improper conduct. Most states do not take veil piercing very lightly since it goes against the purpose of the corporate liability limits under State law. For example, to pierce the corporate veil under many States, it must be shown not only that the wholly-owned subsidiary is a mere instrumentality or alter ego of the parent corporation but also that the subsidiary was organized or used by the parent to mislead creditors or to perpetrate a fraud upon them. We know from our experiences that courts will carefully scrutinize the relationship of a parent corporation and its subsidiary. Thus, for companies who set up a corporate scheme with a parent company and one or multiple subsidiaries, the officers should ensure that the business of the separate entities is kept separate – separate bank accounts, separate contracts, etc.
3. Failure to maintain separate identities of the company and its owners or shareholders.
Along the same lines as parent and subsidiary companies, a similar instance where the corporate veil is pierced is when you have the owners’ personal assets mixed with the company’s assets. One example of when this may arise if the owners create a corporation or LLC but continue to operate out of individual checking accounts, fail to recognize corporate formalities, and use the company’s assets as if they were individual assets. Again, the major best practice here is to ensure distinctness and clear separation between the company and its owners. Owners, shareholders, and officers should avoid commingling funds and must treat assets of the business separate from personal assets.
4. Failure to follow corporate formalities
The final instance that commonly leads to piercing the corporate veil is the failure to follow corporate formalities. For example, an LLC must be filed with the State in order for liability protection to apply. If the owners never file anything, it is not far removed to assume they won’t have liability protection afforded by a formal LLC. Always make sure that you consult with a business attorney if you are going to form a business to make sure the formalities have been followed. Irrespective of whether you are choosing to operate as a corporation, LLC, or otherwise, the owners or officers of the company should be aware of any formalities that they must adhere to depending on the corporate structure and undertake those necessary formalities. This includes properly updating by-laws, maintaining stock or membership ledgers, holding initial and annual meetings of directors/managers and officers, and maintaining status with the State by filing an Annual Report or other required documents (some entities do not require this). Not only is it important as a general business principle, but documentation and records should be adequately kept and stored for purposes of corporate formality as well.
Maintaining Liability Protection
It is worth taking the proper steps to protect yourself from personal liability if you are operating a business. This list is a great start but there is no substitute for having corporate counsel available to make sure you’ve done everything you can to limit your liability. From the creation of your business to the day to day business operations, owners, officers, and shareholders should be mindful of the limits to so-called “limited liability.” If you wish to discuss these potential pitfalls in your business, call our team today.
Dennis E. Sawan
Licensed in Ohio and Florida
Dennis P. Sawan
Licensed in Ohio and Georgia
Christopher A. Sawan
Licensed in Ohio and Michigan
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