Jane is a fictional person who rents out her small cabin on Airbnb to short-term renters. Jane runs her cabin rental business under a limited liability company (LLC) that she set up to reduce, if not eliminate, her personal liability. In between renters, Jane cleans up the cabin to prepare for the next renter. One day, she discovers that something has gone wrong with the water heater, and only boiling-lava-hot water comes out of the faucets. Jane, stressed because she is late for her underwater basket-weaving class, decides to take care of it later, but forgets to do so before the new renters arrive the next day. Lo and behold, one of the renters comes away with fourth degree burns. The burned-renter racks up huge medical bills, scarring, and pain and suffering, so he sues Jane. Jane thinks her personal bank account and other assets are protected from liability because of her LLC.
However, since Jane formed her LLC and began operating her rental business, she has completely disregarded the formalities that are highly recommended of LLC members. For instance, she uses her personal bank account to deposit rental income and pay herself out of, and she does not keep any records of her draws or other business transactions. Jane also does not pay any self-employment taxes (Social Security/Medicare taxes on the net income of the LLC). Further, Jane withdraws money from the account as income in an unorganized way, and without concern for the liabilities of the LLC. Because of her failure to maintain the LLC as separate and apart from herself, the judge in the case brought by the burned man finds Jane personally liable by piercing the corporate veil.
"Piercing the corporate veil" refers to a situation in which a court puts aside the limited liability aspect of a company and holds its owners (i.e., members of an LLC, shareholders of a corporation) personally liable for the company's actions or liabilities. Although the law varies by state, courts often have a strong presumption against piercing the corporate veil, and might only do so if there has been serious misconduct like abuse of the corporate form (e.g. intermingling of personal and corporate assets, complete disregard for corporate formalities) or undercapatitalization at the time of incorporation.
Jane could have possibly avoided liability for this incident had she taken various steps differentiate herself from her company.
LLC Operational Formalities
LLC members should have a well written Operating Agreement in place, with well-defined roles for members, well-outlined distribution guidelines, and other operational and taxation rules.
LLC members should maintain adequate records for all transactions and business matters, as well as properly written minutes of meetings (at least one state, Tennessee, requires an annual meeting of the members). List of members, past and present, articles of organization, tax returns for the past three years, bank statements, resolutions authorizing activities that, either by law or under the terms of the operating agreement, require a vote of the members, etc. are all examples of the types of records and written agreements that should be properly maintained by the LLC's members.
Insufficient capitalization is another important deficiency that a court or tax regulator will examine when determining the intent of the LLC and its member’s, and will often factor heavily in their decision to pierce the veil. Siphoning too many assets or capital and leaving too little in the coffers to satisfy creditors or company operations may lead to a veil-piercing determination.
There are a few other actions/inactions that could lead to the piercing of the LLC veil, which include:
Actions by the members of the LLC that are not covered in the Operating Agreement. Although an LLC is technically not required to observe formalities in the same manner that a corporation is, its actions should be guided entirely by the operating agreement, and the operating agreement is considered by the courts and tax authorities when a determination is made as to the operation of the LLC.
Co-mingling of personal and company funds is never a good idea. Any co-mingling of funds or accounts will almost certainly lead to an “alter-ego” determination by the courts or a tax regulatory board, and will lead once again to veil piercing–thereby risking personal assets and stripping members of the liability and asset protection.
Operational discretion wielded by the members should be governed to ensure that all actions are deemed to be in the best interest of the LLC. Personal agenda’s and game plans should come secondary to the LLC.
The LLC should never, ever be treated as a financial extension of its members. The courts and tax regulatory boards regularly examine the financial dealings and workings of an LLC to determine whether it is a working business or an independent profit center for its owners or members. If it is deemed an independent profit center, the veil could be pierced and there can be tax penalties and liabilities against the owner or members personally.
Lastly, an LLC should pay and guarantee its own debts, unless specifically outlined in the operating agreement for specific requirements for such things as the rental or leasing of real property, etc. Sometimes, if an owner or member regularly guarantees or pays debts, he may have been shown to act as an alter ego of the LLC, which will cause LLC to lose its distinct entity status.
Had Jane abided by these guidelines, she would be in a much better position. We often get clients that come in and are dumbfounded when we ask if they've followed guidelines like this. It is imperative to keep these rules in mind as you operate and grow your business, before it is too late.
Speak with one of our Los Angeles Business Attorneys today!
About the Author:
Dallas P. Verhagen is a business attorney and a partner at Verhagen | Bennett LLP. To learn more about Dallas, please click here.
For questions or comments about this post, please email Dallas directly at: Dallas@VerhagenBennett.com
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© 2017 Dallas P. Verhagen — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.