Preserving the Liability Shield in Closely Held Corporations and LLCsAdded by Steve M. Frinsko in Articles & Publications, Business Law on October 19, 2017
Clients often ask me about the best way to protect their personal assets from their business creditors. My answer is always that they should conduct business through some type of business entity that limits the owner’s personal liability. The two most commonly used entity forms are corporations and limited liability companies, both of which create a liability shield for the owners.
However, simply creating the entity isn’t enough to protect the owners from personal liability. You also have to respect the entity form and make sure that you and your “pretend friend”¹ maintain separate identities. If you don’t, your creditors can break the liability shield (“pierce the corporate veil” in legal jargon) and hold the owners personally responsible for the entity’s debts and liabilities.
Idaho courts will pierce the corporate veil if the creditor proves that (1) the shareholder and the corporation are one and the same “person” and (2) that it would be inequitable not to hold the shareholder personally liable. Similarly, an LLC will be treated as the member’s “alter ego” if the creditor proves those two elements. In practice, the issue is most often decided on the first point—whether the entity and the owner were effectively one and the same person—so I’ll focus on how to preserve the separation of person and entity and reserve the equity discussion for another blog post.
Determining whether the owner maintained the entity as a separate person is a very fact dependent analysis and there is no one silver bullet. But, Idaho case law has identified a number of things that owners can do to preserve the liability shield.
First and foremost, it’s critical that the owners hold the entity out as one that is separate from themselves as individuals. There are many ways to do this. For example, make sure the tenant under the office lease is the entity not the owners. Likewise, be clear that the entity—not the owner—is selling goods (e.g., Acme Soap, not Bill Jones’ soap), and, that the entity owns the equipment used to operate the business. A common mistake I see in leases and other business contracts is that the business owner in advertently signs in his/her name rather than the entity’s name. For example, if Acme Soap, Inc. is making a sales contract, Bill Jones should sign it as “Bill Jones, President of Acme Soap, Inc.” and not simply “Bill Jones.” As I’ve explained here, if Bill just signs “Bill Jones,” without more, this can make Bill personally liable for those contractual obligations that should have belonged to Acme (even without the need for veil-piercing).
A related example that covers two shield-preservation factors, is that the entity’s money should be kept in bank accounts opened under the entity’s name. Having separate personal and entity bank accounts is a strong indicator that the owner held herself out as separate from her entity (and thus maintained the liability shield). The owners also need to make sure that business debts are paid out of the business account and personal debts out of the personal account. Using business accounts for personal debts (or vice versa) is a strong indicator that the entity and the owners are one and the same. Thus, a court would likely not look favorably on an LLC that used LLC funds to pay private school tuition for the member’s children.
This isn’t to say that paying out of the wrong account is a kiss of death—it’s not. But, it has to be accounted for properly. For example, in the case of the LLC paying tuition, the best way to handle that would be for the LLC to make a distribution to the member (assuming enough money was legally available for the LLC to make the distribution) and for the member to then pay the tuition out of her account. The effect is the same but the accounting is proper. Likewise, a parent entity may pay debts of its subsidiaries and preserve the liability shield as long as the subsidiaries reimburse the parent for those debts.
Less commonly, another factor that courts consider is whether the entity’s initial capitalization was adequate to meet the entity’s “reasonably foreseeable potential liabilities.” For example, the member who caused the LLC to take on liabilities of $1 million might be personally liable for the LLC’s debts if he capitalized the LLC with $10 of cash and provided no real means for the LLC to generate revenue. The court would likely reason that the LLC was formed as a sham in an attempt to avoid personal liability because it had no cash to repay that debt and no real expectation of ever earning any cash to pay the debt. Note that this wouldn’t apply in the case where the LLC was properly capitalized at the outset but then got overextended later on. Things happen in business and courts respect that, but they don’t respect attempts to unfairly shield the owner from personal responsibility.
Lack of proper internal approvals is a factor that courts commonly cite in support of their decision to pierce the corporate veil. Many corporate bylaws require that the board of directors approve (among many other things) corporate borrowing or purchases of real property. Thus, absent board review and approval, those acts may be outside the corporation’s scope and the shareholders might be held personally liable. This most commonly occurs in closely held corporations where the shareholders and the board of directors are one and the same and the corporate records are not complete (or don’t exist). It also happens in situations where the owner purportedly acts on behalf of the company but before the company is created. Ordinarily, the entity will ratify those acts as its own and absolve the owner of personal liability but occasionally (such as when the other owners view those acts as being inconsistent with the entity’s business) the entity doesn’t and the owner is personally responsible.
Finally, and related to lack of proper approvals, courts commonly cite the failure to adhere to corporate formalities to support their conclusion that the corporation and the shareholders are the same person. All corporations, regardless of the number of shareholders, are required to have a board of directors and to have shareholders meetings and to observe a number of other corporate formalities. However, small corporations often neglect to properly document these meetings and to keep complete corporate minute books (or to even hold meetings at all). This isn’t to say that small corporations (or large ones for that matter) need to get bogged down in the details of corporate recordkeeping at the expense of operating the business. The formal portions of the annual shareholders and directors meetings can be accomplished in just a few minutes and documented in just a few minutes more. And, Idaho corporate law specifically provides that acts requiring a director or shareholder vote may be accomplished in writing without a meeting. So, a resolution signed by all of the shareholders and directors accomplishes the same purpose as a meeting, and creates a record to boot.
LLCs, by law, aren’t required to follow the same level of formalities as corporations and the courts have recognized this factor doesn’t apply in the “alter ego” analysis for LLC members. This lack of required formalities is one of the reasons people often choose to form an LLC rather than a corporation. Nevertheless, it’s a good idea to get in the habit of documenting major LLC decisions and creating a record of the thought process of getting to that decision. This can help prove that the LLC remained separate from the members and can also be helpful if a dispute ever arises among the members.
The Idaho courts, to keep their options open, have stated very clearly that the list of factors outlined in this blog post is not an exclusive list. Thus, there may be other factual circumstances that lead to veil piercing. However, these are the most commonly cited factors and should serve as good guideposts for preserving the liability shield and keeping your business creditors out of your personal pocketbook.
¹Thank you, Professor Anderson.
Steve Frinsko is a transactional attorney in the firm’s business and real estate law departments.
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