Once you have organized your business, you are still not entirely immune from personal liability. When courts impose liability on individuals for the actions of the corporation, this is referred to in legal parlance as “piercing the corporate veil.” In order to avoid personal liability for debts and other acts of the corporation (or LLC) you must run your business entity as a truly distinct and separate entity from the personal affairs of each owner.
The corporate shield cannot merely be a façade with no real business purpose and the business should display characteristics resembling an actual, ongoing business. In closely-held corporations (very few shareholders), the same individuals tend to act in several different capacities, and this requires an effort to maintain those distinctions. Not to mention, owners of small businesses tend to naturally treat all income as personal income and use business assets for personal use.
The courts typically look at whether there is “a unity of interest and ownership such that the separate personalities of the entity and the owner no longer exist and upholding the distinction between the owner and the entity would be an injustice.” In other words, if the corporation or LLC is the alter ego of the individual and recognizing the distinction would be unjust or fraudulent, the veil will be pierced. It is impossible to describe everything you must do to avoid having the corporation or LLC seen as a mere extension of the owner. However, it is important enough that you must have a basic understanding of what you should and should not do to help insulate yourself from personal liability.
A member of an LLC or shareholder of a corporation can be held personally liable for many different types of claims, but they typically arise under these different scenarios:
1. Claims arising out of an act or omission by the owner directly, such as the owner’s own negligence, fraud, illegal act or violation of a fiduciary duty;
2. Claims arising out of a contract, particularly one that was personally guaranteed by the member;
3. Liability for unpaid employment taxes, wages, worker’s compensation insurance and unemployment contributions;
4. Claims based on the concept of “piercing the veil” of the LLC;
5. Liability for consenting to or receiving a distribution in violation of the LLC’s operating agreement or the applicable LLC statute.
These claims are not a result of choosing an LLC over a corporation, or vice versa. All of these exceptions apply equally to shareholders in corporations and members of LLC’s. But, there are many exceptions to the rule of limited liability. Many LLC members or shareholders will find that, due to the way the business was operated, the promised protection from the liabilities and claims of the business is not meaningful.
Important Factors Used to Pierce the Veil
The courts will generally determine whether or not you, or the other owners, have conducted the business as a separate and distinct entity, and not as the ‘alter ego’ of the owner(s), as stated. But what actions or non-actions by the owners demonstrate this in the eyes of the courts? State courts will look at all of the separate facts and the circumstances of each case to determine whether or not to pierce the corporate veil. There are some common factors that show a court your business was set up as a sham or was an extension of yourself. Under capitalization, where it is clearly shown, is an important factor. But, it is not an absolute ground for piercing the corporate veil by itself without other factors existing.
Here are the most common and key factors considered by the courts in determining whether to pierce the corporate veil:
1. Whether the corporation follows corporate formalities (I.e., creating and following the requirements and procedures set forth in the bylaws, keeping minutes of shareholder and board of directors meetings and creating resolutions for important company actions);
2. Absence of corporate records;
3. Inadequate capitalization. The corporation is under-capitalized at the time transactions with creditors or others wishing the corporate veil to be pierced were entered, or simply not enough capitalization to get the particular corporation running). State laws govern the formation of a corporation. Inevitably, these laws set forth amounts or formulas for determining the minimum capitalization amount required for a corporation. You must review the laws in your state to determine the amount and make sure you meet the contribution minimums. Simply put, the lack of capitalization means the corporation was never a viable entity because it had insufficient funds to back debt obligations;
4. Whether the major shareholders are using money from the corporation for their personal use (I.e. when the shareholder(s) takes money from the corporation to pay their personal bills or buy gifts for themselves, etc.) or where they use other assets for personal use or gain;
5. Non-functioning of other officers or directors (having officers and directors who do nothing and were put in place by a majority shareholder, but are not actively involved in the directing the business and affairs of the corporation);
6. Commingling of funds and other assets between major shareholders and the corporation (or LLC);
7. No corporate assets whatsoever;
8. Use of corporation to transfer liability of another (usually a shareholder);
9. Failure to issue stock and non-payment of dividends;
10. Failure to keep records of expenses and gross receipts;
11. Contracting with another without the intent to ever perform on the obligations;
12. Failure to maintain arms-length transactions with third parties.
These are not the only factors the courts have considered, only some of the most common and ones you should absolutely follow at all times.
Piercing the Corporate Veil of LLC’s
Generally, a member or manager is not personally liable for a debts, obligations, or liability of the LLC solely by reason of being or acting as a member or manager. However the concept of piercing the corporate veil does apply to LLC’s and the courts can and have permitted members of LLC’s to be personally liable in some instances. Some states including Minnesota and Colorado have adopted statutes that specifically apply the concept of piercing the corporate veil to LLC’s. In other jurisdictions, such as Connecticut, Louisiana, Georgia, California, etc., it is the courts that have generally applied the concept of piercing the corporate veil to LLC’s through case decisions.
Despite what you hear about LLC’s, the Members will be personally liable if the corporate veil of the LLC is pierced by a court similar to shareholders. The courts will apply the same general alter ego analysis used for piercing corporations, but sometimes without regard to a lack of corporate formalities. While some corporate formalities do not have to be followed under the LLC organizational statutes, this does not give the members of an LLC carte blanche to operate as they please and avoid personal liability. For instance, annual meetings are not required under most state LLC statutes nor is there any detailed notice requirements for meetings and elections. But, certain corporate formalities common to both entities should be followed the same basic recommendations that corporations must follow should be followed by owners of an LLC operating an Internet business.
Actions of an Owner as a Director, Officer or Manager
Shareholders, officers, directors and members of an LLC are always personally liable for their individual criminal acts. They are also always personally liable for their own direct acts or omissions that result in harm to persons or property (I.e. torts), even when those acts were done during the course of company business. For instance, if you are an electrician and you leave a faulty wire exposed, the fact you have formed an LLC will not shield you from this negligence.
Similarly, if you drive the company vehicle and injure someone on your way to a business meeting, you are still always personally liable for your own personal actions. To the extent you direct or authorize in your capacity as director, officer or manager an action that is or results in a criminal act or causes damage to persons or property, you can be held personally liable. Every member who actively participates in the business of the LLC or corporation runs the risk that his action or inaction will result in personal liability. This is particularly a risk of a service business in which the members provide the key service. In the example I used above, if you are an electrician and you leave an exposed wire that electrocutes someone, your LLC is not going to protect you. The same thing holds true if you are a shareholder.
If you make promises about your product or service that are not true, there may be a claim against the entity for breach of contract. However, if the LLC cannot perform or pay damages, the injured party may come after you for fraud or a similar claim based upon your own action. Even if you have an employee who committed the action, you may not be out of the woods. If you personally hired the employee, the injured party may have a claim against you for negligent hiring if a reasonable person would not have hired that employee.