In this article I discuss how a LLC generally shields its members from liability and to what extent this protection is limited. The distinct advantage of the LLC over other unincorporated entities such as the partnership and sole proprietorship is that it insulates the owners from any of the debts and liabilities of the company. However, this protection is not absolute and there are several ways in which members of the company can lose this protection. The biggest misconception I see from clients is that they believe a LLC will protect them from litigation in almost any situation. This is simply not true, a person will always be liable for his or her own fraudulent, reckless, or illegal behavior. In other words, if you back out of your driveway on the way to work in the morning and ram your neighbor’s car you can’t jump out and yell: “Not my fault… I have an LLC.” It doesn’t work that way you will always be liable for your personal actions.
How Members are Protected:
Generally, when a company is sued by a creditor or supplier for any unpaid debts the members of the LLC will not be held liable for any deficiencies. This simply means that creditors of the business can reach the company assets however once those assets are exhausted creditors cannot go after any of the member’s personal assets to make up the difference. Therefore, the members of the LLC stand only to lose the money they contribute to the company.
Limitations of Limited Liability:
Here are some instances when a member may be found liable regardless of his or her membership in the LLC:
1. Negligence or Fraud of an Individual Member: As mentioned in the opening paragraph the general rule is that an individual member of an LLC will always be liable for his or her own torts. This means that if you personally act fraudulently, recklessly, negligent or illegally to cause harm to someone else or the company you can be held personally liable for those actions even if such action were undertaken in a business capacity.
2. Personally Guaranteeing LLC Debts: This is another misconception of clients. In almost every major transaction of the LLC such as buying real estate or vehicles the banks and creditors will require that the members agree to be personally liable for LLC debts before extending credit to the company. In these cases if the LLC subsequently defaults the members will be held liable for any deficiencies.
3. Piercing the Veil: Courts will hold an individual member personally liable for LLC obligations in three reoccurring situations: i) when company formalities are ignored; ii) when the LLC is inadequately capitalized at the outset, and iii) to prevent fraud.
Steps To Avoid Personal Liability:
Upon formation the LLC the members should take all necessary steps to treat the LLC as an entity separate and apart from the members. The following list should always be followed when setting up a new LLC:
1. Obtain a Employer Identification Number (EIN): An EIN is a tax identification number that the IRS uses to identify business entities. It is to businesses what the social security number is to individuals. You many apply for an EIN online HERE.
2. Open a separate bank account in the name of the LLC: A bank account should immediately be opened in the name of the LLC and the cash contributions of the members should be immediately deposited in this account.
3. Do not commingle LLC and personal accounts: Members should never pay for their personal expenses out of the LLC account and should never cover business expenses with their personal accounts.
4. Adequately capitalize the LLC: Adequate capitalization really depends on the unique demands of each business. Based on the day-to-day activities of the LLC the members should make sure that there is enough capital in the LLC to cover any reasonably foreseeable liabilities.
5. Obtain business liability insurance: Business insurance and umbrella policies provide members a funding source other than their personal assets should they become liable personally because of their own misconduct or negligence.
6. Follow formal LLC procedures: One of the biggest mistakes that members make is failing to properly indicate that they are signing LLC documents on behalf of the company. Any document signed by a member on behalf of the company should specifically state that the member is signing on behalf of the company. In addition, all LLC business should be properly conducted as dictated in the company’s operating agreement. This includes electing officers for the company, following proper voting procedures, and holding annual meetings and recording company minutes.
7. Be Ethical: Acting responsibly and in good faith with your business creditors and customers will go along way in avoiding personally liability. Courts are always more willing to pierce the veil of a LLC if there are indications of misconduct on behalf of the members.
If used the way it was intended the LLC can prove to be a valuable tool insulating business owners from activities arising solely out of the business.
John Thompson is a shareholder with Kennedy Berkley Yarnevich & Williamson, Chartered assisting entrepreneurs, families and farmers in the areas of estate and business planning.