November 14, 2016
You have been kicking around a great idea for a business for the past two years and you are finally ready to turn your dream into a reality. After assessing the advantages and disadvantages of various business structures, you determine that the business entity that best fits your needs is a limited liability company (an “LLC”). You (or your attorney) file the requisite paperwork to set up the LLC and it is officially organized. Now what?
Among the numerous concerns that a business owner must pay attention to (e.g., hiring employees, establishing safeguards for protecting confidential information and trade secrets of the business and managing company cash flow), one of the key concerns that a business owner should focus on is how to protect the limited liability protection that an LLC affords its owners (who are generally referred to as the LLC’s “members”). One of the advantages of forming an LLC is that, because an LLC is viewed as a legal entity that is separate and apart from its members, the members of the LLC have limited personal liability for the debts of the Company. This limited liability shield protects members from being held personally responsible for the debts of the LLC, should the LLC be unable to pay its creditors, and, further, prevents creditors from seeking recourse against the members’ personal assets.
However, in a few rare and extreme instances, courts may disregard the limited liability protections afforded to the LLC’s members and hold the members personally liable for the debts of the LLC (often referred to as “piercing the veil”). If this occurs, the members’ bank accounts, real and personal property interests and investments may be at risk. While there is no set list of factors that must be present for a court to “pierce the veil” and hold the members personally liable, there are certain factors that a court may take into consideration when determining whether such an extreme remedy is appropriate, such as:
- Commingling Assets. The members should not commingle their personal assets with the assets of the LLC. For example, the members should not use the LLC’s bank account for their own personal use (e.g., writing a check from the LLC’s bank account to pay for their child’s school tuition). Also, the members should not deposit funds that are payable to the LLC into their personal accounts (e.g., checks payable to the LLC for services provided by the LLC should not be deposited into a member’s personal bank account). Immediately upon formation of the LLC, the members should obtain (and maintain) a separate bank account for the LLC.
- Failure to Create Separation between the LLC and its Members. It is important that the members treat the LLC as an entity that is separate and apart from its owners, and ensure that all third parties doing business with the LLC understand that their business relationship is with the LLC, and not with the members. The LLC’s full name (including the “LLC” or “L.L.C.” identifier) should be used on all contracts, invoices, business cards and letterhead. When engaging in business on behalf of the LLC, members should sign in their official capacity (e.g., John Smith, President of ABC LLC). Using a designated email account that includes the LLC’s name (or some approximation of the name) is a good way to establish this distinction, as well as the use of email signature blocks indicating the LLC’s name and the title / capacity of the member acting on behalf of the LLC (i.e., “Manager”, “President”, etc.).
- Failure to Follow LLC Formalities. Certain states, such as New York, require that the members of the LLC enter into a written Operating Agreement which sets forth, among other things, the economic and management rights and obligations of the members. Business owners may wish to discuss any specific complexities with counsel (e.g., rights of first refusal, transfer restrictions and drag-along provisions), to ensure that the business terms are properly reflected in the Operating Agreement. Members should adhere to the requirements set forth in the LLC’s Operating Agreement. For example, if the LLC’s Operating Agreement states that the members are required to meet once a year, or if it states that certain decisions must be approved by a supermajority of the members, those provisions should be complied with, unless waived in accordance with the provisions of the Operating Agreement. The LLC should keep detailed books and records, which should include copies of the organizational documents of the LLC (including its Articles of Organization and Operating Agreement, and all amendments thereto), all signed resolutions, minutes of all meetings, a list of all of the members and details relating to the financial picture of the LLC. Additionally, the business activities of the LLC should be properly documented and, to the extent required, approved by the appropriate members and/or managers of the LLC. Further, certain states require that LLCs file annual or biannual reports with the Secretary of State of the state of formation of the LLC. Failure to file such reports may lead to dissolution of the LLC.
- Liability for Non-Payment of Wages. Under New York law, the ten (10) members with the largest percentage ownership of a New York LLC can be held personally liable, jointly and severally, for all unpaid wages or salaries owed to any of the LLC’s employees. Members of LLCs with significant stress on their cash flow may have an increased risk of exposure if the LLC fails to pay the wages owed to its employees. Additionally, because liability for unpaid wages is joint and several, employees can elect to recover amounts owed in respect of such unpaid wages from one, all or any number of the top ten (10) members of the LLC (any member who has paid more than his or her pro rata share of such wages is entitled to contribution from the other members). Further, the law makes clear that “wages and salaries” extend beyond an employee’s base salary, and include “all compensation and benefits payable by an employer to or for the account of the employee, servant or laborer, for services performed by them for such limited liability company”. New York Limited Liability Company § 609(d). This includes overtime, vacation, holiday and severance pay, employer contributions to or payments of insurance or welfare benefits and employer contributions to pension or annuity funds.
- Failure to Adequately Capitalize the LLC. Upon formation of the LLC, members should ensure that the LLC’s bank account has a sufficient amount of money to account for its business operations. The LLC should endeavor to keep a balance between debt and equity that is appropriate for the type of business that the LLC operates.
The list above is not a comprehensive list of all of the factors that a court may take into account in considering a veil piercing claim. Rather, this list is a small subset of factors that business owners should consider when forming and operating LLCs. For more information on LLC formation and protecting an LLC’s limited liability, please contact the authors Lindsay Kaplan and Jeffrey Davis.