An Overview of LLCs
B.
Exceptions to Owners' Limited Liability
While LLC owners enjoy limited personal liability for many of their business transactions, it is important to realize that this protection is not quite absolute. In several situations that I discuss below, an LLC owner may become personally liable for business debts or claims. This drawback is not unique to LLCs -- many of these same exceptions apply to all limited liability business structures, including corporations. The limited liability protection held by LLC members is just as strong (if not stronger) than that enjoyed by the corporate shareholders of small corporations. (To find out why, see "Losing Your Limited Liability," below.)
That said, let's look at the most common ways an owner might not be protected by limited liability.
Personally Guaranteed Business Debts
No matter how a small business is organized, whether as an LLC, a partnership, or a corporation, its owners may be asked to sign bank loan obligations or to personally guarantee to pay business debts. Owners who agree to this voluntarily give up their limited liability protection as to the personally "cosigned" loans.
Example: A married couple owns and operates Books & Bagels, a coffee shop and bookstore. In need of dough (the green kind) to expand into a larger location, the owners ask a bank for a smallish loan. The bank grants the loan to the LLC on the condition that the two owners personally pledge their equity in their house as security for the loan. Because the owners personally guarantee the loan, if the LLC goes broke, the bank can seek repayment from the owners personally. If they can't come up with the cash, the bank could even foreclose on their house. No type of business ownership structure -- an LLC, a corporation, or a limited partnership -- can protect owners if they choose to assume personal liability.
But don't worry: Even if you have to personally cosign a business loan from time to time, there are plenty of other situations where your LLC's limited liability protection remains intact. That's because most of your business debts -- and possibly even loans you negotiate with individuals -- will not also be personal debts. For instance, your LLC's lines of credit with vendors and other suppliers and all its routine bills are debts of the LLC only, not personal debts of the LLC owners. In short, unless you go out of your way to pledge personal assets for business debts, you'll have no personal liability for them.
Injuries to Others (Torts)
Like it or not, members and managers of an LLC, like corporate directors and shareholders, partners, and all other business owners, can be held personally liable for financial loss caused by their own careless behavior. Called "torts" in legalese, negligent acts (such as those that result in car crashes) are the everyday stuff of American litigation. For example, carelessly running a red light, causing an accident and damaging another automobile, is a tort. But while an LLC member or manager is personally responsible for his or her own negligence (if the LLC can't or doesn't pay), the good news is that personal liability for torts does not typically extend to the other LLC members. Or put another way, in a two-member LLC, Member One is personally liable for his or her own negligent acts, but not for those of Member Two.
Example: Otto, one of the two members of Otto's Auto Parts Supply LLC, drives the LLC's Mazda Miata to pick up a throw-out bearing for a customer's Mercedes SUV. On the way, he negligently sideswipes a slow-moving Geo, a stunt that results in a $5,000 repair bill for damage to the Geo and a $25,000 medical claim for whiplash to George, the Geo driver. If insurance doesn't cover George's damages, Otto can be held personally liable for the $30,000 (the LLC itself can be liable too if the accident happened on company time). But Mike, the other owner of the LLC, shouldn't be held personally liable for Otto's careless driving, nor should he be held personally liable if George obtains a legal judgment against the LLC itself.
Although LLC law does not protect members and managers from the consequence of their own torts, insurance can. Commercial, automotive, workers' compensation, or even the individual's homeowner's policy may cover some or all of the damage caused by an LLC manager's or member's tort. But don't rely on personal policies to provide business-related protection. It's essential to get a reasonable amount of appropriate liability insurance to cover potential personal and business liabilities arising from LLC operations. Typically, a commercial general liability insurance policy will cover the following:
- torts caused by business owners and employees in the course of business or on the business premises (a policy for bodily injury and property damage -- so-called "slip-and-fall" coverage), and
- fire, theft, and a long list of catastrophes.
Of course, a general liability policy won't cover damages caused by a member's illegal or fraudulent behavior.
 Professionals should take special considerations into account. If an LLC is organized to render licensed professional services such as health care, law, accounting, architecture, engineering, and similar services, state law normally renders each individual professional personally liable for his or her own malpractice, even if the business is organized as a corporation, LLC, or RLLP. That's why it's essential for each person to purchase adequate malpractice insurance to cover this additional professional tort liability.
Professionals who are considering forming an LLC should also know that many states do not specifically protect a professional in a multimember LLC from personal liability for the malpractice of other professionals in the firm, so it is yet to be seen whether professional LLCs will protect their owners from this sort of "vicarious liability." However, all states have enacted statutes that allow certain professionals to form registered limited liability partnerships (RLLPs) instead of LLCs, which may provide broader protection from liability for another owner's malpractice. (See Chapter 2.)
Breach of Duty to the LLC
In a co-owned LLC, the managers (either its members in the case of a member-managed LLC or its specially appointed managers in the case of a manager-managed LLC) have a legal obligation to manage the LLC in good faith and in the best interests of the LLC and its members. This is known as their "duty of care," and is similar to corporate directors' and officers' duty to their corporation. If a member or manager of an LLC violates this duty of care, he or she can be held personally liable for any money damages that result.
Although it sounds threatening, this duty of care is a fairly relaxed legal standard. Managers have been held to violate it only if they do something intentionally fraudulent, illegal, or so clearly wrongheaded that a fair-minded person would conclude they were taking a grossly negligent risk. In short, LLC members and managers are not normally personally responsible to the LLC or other members for any honest mistakes or acts of poor judgment they commit in the execution of their job-related duties.
LLC members and managers in smaller LLCs often rely primarily on commercial liability insurance to protect them from lawsuits brought by outsiders, at least at the beginning of LLC operations. If they can afford to, they may decide to back up this basic coverage with appropriate personal liability policies covering members or nonmember managers for "insider" and other management-related lawsuits. Policies of this sort protect LLC members and managers from personal liability for their management decisions (these policies should be distinguished from commercial liability insurance policies, which insure the LLC against catastrophic damage and injuries to employees and outsiders).
The duty of care applies to managers' actions toward all members of the LLC. For example, in a manager-managed LLC, the nonmanaging LLC members can sue a manager who knowingly entered a fraudulent transaction that hurt the LLC financially for breaching the duty of care. And in member-managed LLCs, a member who violates the duty of care might be personally liable in a lawsuit by the other members.
Example 1: Fred is the sole manager of a real estate LLC. The LLC owns an apartment building, which Fred manages. Because of high tenant vacancies and extra repair costs, the LLC reports a loss for the year and is unable to distribute profits to its members at the end of the year. The nonmanaging members sue Fred for failing to properly manage the LLC. As long as Fred has done his best to obtain tenants and make reasonably necessary repairs, he should be able to show that he has met his duty of care -- and, therefore, win the lawsuit.
Example 2: Robert, Juliet, and Greg are the three owners of the Lucky Lock Company LLC, a member-managed LLC. They vote at a management meeting on whether to use one-quarter of the company's cash reserves to market and sell the Neon Big-Lock Clock, a unique, three-by-five-foot lock plate with a neon clock display, which Robert invented. Greg is against the idea of committing company funds to promote a device that he believes no one will buy. But Robert and Juliet disagree with Greg, believing that the big clock will find a market. The neon clock idea does not catch on and Lucky Lock goes broke. Greg sues Robert and Juliet in their personal capacity. The judge finds that, although they made what turned out to be a bad business decision, Robert and Juliet did so armed with all the facts and in good faith, and did not breach their duty of care.
But now let's change a few facts and assume Bob and Juliet have researched the availability of certain key parts and know that several would have to be custom-made, which means the Neon Big-Lock Clock will be very difficult and expensive to produce. Instead of telling Greg these facts, they keep their knowledge secret and vote to go ahead with the project. This time when Greg sues, the judge supports his claim and finds that Juliet and Robert have breached their duty of care. Greg is awarded a significant judgment.
Robert and Juliet were liable in the second situation because of the way courts have interpreted a business owner's duty of care. A company's management has to follow the "business judgment" rule to avoid liability. This rule says that in making management decisions, managers will not be personally liable for honest business mistakes. Decisions that have some rational basis (based on facts known to managers or reported to them by someone with superior knowledge) should not give rise to personal liability even if they turn out to be mistaken and result in financial loss to the business and its owners. Let's go back to the Lucky Lock Company and change the scenario one more time.
Example: Again, Robert, Juliet, and Greg discuss at a management meeting whether to use one-quarter of the company's cash reserves to market and sell the Neon Big-Lock Clock. This time, Robert and Juliet disclose to Greg that certain essential parts would be very difficult and expensive to produce. Based on this disclosure, Greg is even more against the idea of committing company funds to promote a device that he is strongly convinced will not appeal to many customers. Greg's opinion, along with the information that casts doubt on the profitability of the Neon Big-Lock Clock, is fully discussed at the membership meeting. Nevertheless, based on their experience in the clock business and the fact that many offbeat designs (for example, the cuckoo clock) have been extremely profitable, Robert and Juliet vote to proceed (and Greg is outvoted two to one).
Again, the Neon Big-Lock Clock is a disaster. Can Greg successfully sue the other owners personally for their bad business judgment? No, according to the business judgment rule. Robert and Juliet made an informed business decision without underhandedness, concealment, or misrepresentation of facts, or other fraud or illegality. The fact that they guessed wrong should not make them personally liable to Greg.
Disclose, Disclose, Disclose! The above example highlights a basic LLC management rule: Full and fair disclosure of all material facts is part and parcel of LLC managers' and members' duty of care to the LLC. As long as this duty is met, the business judgment rule will normally protect members and managers from personal liability for their management decisions.
But what if an LLC member or manager is sued for breaching his or her duty to the LLC? Even if the member or manager who was sued ultimately wins, can't the costs of suit alone be disastrous to the defending member or manager? Not necessarily. When a member or manager is sued for breach of duty of care to the LLC but prevails, the laws of many states permit or require "indemnification" by the LLC. This means that the LLC must pay any legal expenses, fines, fees, and other liabilities owed by the LLC member or manager for ill-advised management decisions or other liability-causing events. But again, state rules often require the person to be indemnified to have acted in good faith and in the best interests of the LLC to receive indemnification. And, as you might guess, intentional misconduct, fraud, and illegal acts normally aren't covered under these rules.
 Financially irresponsible acts can also lead to a loss of limited liability. As I mentioned above, an LLC must satisfy certain financial standards before a managing member or a manager can approve a distribution of profits. In short, these standards mean that an LLC shouldn't pay out profits if it can't afford it. If these standards are ignored and the company is later sued, the member or manager who approved the distribution may be personally on the hook for the amount of the invalid distribution. See Chapter 4 for more on this.
Losing Your Limited Liability
In the situations above, LLC members can be held personally liable for acts that occur in the course of their business. But the limited liability status of the LLC itself can also be lost, if a court finds that you didn't run the LLC as a separate business entity.
Because the LLC is a relatively new business form, state courts have not had much time to flesh out all the legal implications of doing business as an LLC. The result is that there are not a lot of court decisions dealing with the issue of when an LLC should be treated as a sham entity and its members held liable in their personal capacities.
On the other hand, state courts have had plenty of time to discuss and interpret the limited liability protection that corporations provide to their owners, and to carve out exceptions to a corporation's limited liability status under extreme circumstances. Most legal commentators believe that state courts will follow the guidelines set out in these corporate cases when the limited liability protection offered by an LLC is challenged in state court. Because I agree that this is likely to happen, it makes sense to briefly look at instances where courts are likely to disregard a corporation's separate legal status and hold its owners personally liable (in legal slang, "pierce the corporate veil").
Generally, corporate limited liability protection will be disregarded -- that is, the corporate owners will be held personally liable for business debts and claims -- only in extreme cases. Most typically this occurs when owners fail to respect the separate legal existence of their corporation, but instead treat it as an extension of their personal affairs. For example, if owners fail to follow routine corporate formalities, such as adequately investing in or capitalizing the corporation, issuing stock, holding meetings of directors and shareholders, and keeping business records and transactions separate from those of the owners, a court is likely to find that the corporation doesn't really exist and that its owners are really doing business as individuals who are personally liable for their acts.
What does all of this mean for an LLC? Well, for starters, because many states' statutes specifically allow LLCs to act more informally than corporations (for example, not hold regular meetings), the failure to adhere to annual-meeting-type formalities should not be a problem. But you should follow these basic precautions:
- Act fairly and legally. Do not conceal or misrepresent material facts or the state of your finances to vendors, creditors, or other outsiders. Or put more bluntly, don't engage in fraud.
- Fund your LLC adequately. You don't have to invest a lot of money in your LLC, but do try to put enough cash or other liquid assets in at the beginning so your LLC will be able to meet foreseeable expenses and liabilities. If you fail to do this, it is possible that a court faced with a balance sheet that shows a very minimal investment may disregard your LLC's limited liability protection. This is particularly likely if you engage in a risky business that obviously requires a large investment.
- Keep LLC and personal business separate. Nothing will encourage a court to disrespect your LLC entity more than your own failure to respect its status as an entity separate from its owners. This means you'll want to open up a separate LLC business bank account. As a routine business practice, write all checks for LLC expenses or payouts of profits out of this account, and deposit all LLC revenue into it. Do all of this even if you set up a single-member LLC. And of course, you will want to keep separate accounting books for your LLC -- these can consist of a simple single-entry system, such as your LLC check register and deposit slips, but a double-entry system will serve you better when it comes time to prepare your end-of-year income tax returns, especially if yours is a multimember company, which will have to prepare and file IRS Form 1065, the informational return for partnerships (see Chapter 4). Lastly, you should keep written records of all major LLC decisions.
When Personal Creditors Can Go After LLC Assets
As explained above, the LLC's limited liability shield protects the personal assets of LLC owners from lawsuits that arise from LLC business operations and claims, with a few exceptions. However, this protection doesn't always work the other way -- that is, an LLC owner's business assets are not necessarily protected from creditors seeking to satisfy personal debts or lawsuit judgments against the owner.
In most states, a personal creditor of an LLC owner can seize the owner's interest in the LLC. Because an interest in an LLC is the personal property of each LLC owner, personal creditors are typically allowed to obtain a "charging order" against the owner's interest in a business, such as a partnership interest, an LLC interest, or stockholdings in a corporation. Essentially, a charging order is a lien against the owner's business interest, which allows the creditor to receive profit payments that would otherwise go to the owner.
Example: Sam defaults on a personal bank loan unrelated to his LLC business, and the bank obtains a charging order against Sam's LLC membership interest. This order allows the bank to be paid any profits that would otherwise be distributed to Sam under the terms of the LLC's operating agreement.
A charging order may not do a creditor much good if an LLC does not regularly distribute profits to members. In that case, the creditor may be able to ask a state court to foreclose on the LLCs member's interest. If state laws allows this and the court agrees, the creditor can become the new legal owner of the LLC. However, under most state laws, a creditor who forecloses on an LLC interest does not become a full owner. Instead, the foreclosing creditor becomes a "transferee" or "assignee" who is entitled to all economic rights associated with the interest, such as a share of the profits paid out on the interest and the value of the interest when the business is sold or liquidated. Typically, an assignee or transferee cannot manage or vote in the LLC, nor assume other membership rights granted to full members under the LLC operating agreement. Again, however, if the LLC does not pay out profits regularly and there is little chance of the business being sold or liquidated, these economic rights might not mean much to a creditor.
Some states allow transferees or assignees of LLC memberships to petition a court to force a dissolution of the LLC. This is an extreme remedy that may be available to creditors who can foreclose on an LLC membership interest in some states. To determine whether an LLC owner's personal creditor can obtain a charging order, foreclose, and/or force a dissolution of your LLC, consult a knowledgeable business lawyer.
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