It may seem obvious to say so, but a key reason that many solo small business owners form single-member limited liability companies (SMLLCs) is to gain the protection of limited liability. This article provides a general overview of how limited liability protection could be lost.
By default, all limited liability companies (LLCs), including single-member LLCs, are assumed to be separate entities from their owners (who are also their respective companies' members). Because of this assumed separateness, SMLLCs as a rule do not share liability with their single owner/members. Among other things, this means that if an SMLLC has unpaid debts or harms people, it normally is the SMLLC alone that is held legally responsible.
However, there are situations where the normal LLC rules don't apply. The so-called veil that protects an SMLLC owner from the SMLLC's liability can be pierced (set aside) if a court decides that the SMLLC isn't truly a separate entity from its owner. Moreover, some evidence suggests that this is more likely with an SMLLC than with a multi-member LLC.
The rules relating to the relationship between LLC liability and personal liability historically are concerned with multi-member LLCs. Liability laws specifically for single-member LLCs are relatively new, and are still an evolving area of the law. You may want to check elsewhere on this website for state-by-state rules on liability for SMLLCs.
Moreover, it's worth keeping in mind that the requirements for piercing the LLC veil are taken from older laws relating to liability of corporations. As a rule, corporation law predates the invention of the LLC form. Because corporations have important differences from LLCs—for example, corporations have more required formalities—the rules for corporations are not always easily transferred to LLCs. Courts in some states have recognized this fact and specifically tried to make adjustments in their rules for how to decide LLC veil-piercing cases.
In many legal cases that deal with piercing the limited liability veil, the question is whether a company is truly separate from its owners and members. However, there are situations where you won't be protected from personal liability regardless of whether your SMLLC is considered separate from you. For example, you are personally liable if you personally guarantee a loan for your business. Furthermore, you can be held personally liable for your own careless actions if you injure someone while operating your business. And, if you're a professional, you can be held personally liable for your own malpractice. However, the latter exceptions aside, if you form your small business as an SMLLC, and observe a few basic rules (such as keeping business finances separate from personal finances), you should be personally protected from most kinds of business liability.
In certain cases, an SMLLC may be sued and a court may enter a judgment against the company. Key instances where this might happen include the SMLLC not paying business debts or the SMLLC being responsible for physical harm to customers or clients. Courts generally take limited liability very seriously in these situations. If the SMLLC is not able to satisfy the judgment (which generally means paying money), courts typically will not allow the injured party to pierce the limited liability company veil and go directly after the SMLLC owner.
However, under certain conditions, courts will set aside limited liability. In those rare cases, a person with a money judgment against an SMLLC could, for example, go after the single member's personal bank accounts, personal investment accounts, and home.
The exact conditions necessary to allow a plaintiff to pierce the LLC veil vary from state to state. However, in general terms, two factors must be present.
First, there must be a unity of interest between the SMLLC and its member. In other words, the injured party must show that the SMLLC is not really a separate entity from its sole member. The legal system has special phrases for this situation, such as that the business is a mere alter ego of its owner, or is a mere instrumentality of its owner.
Second, the injured party must show that piercing the limited liability veil is necessary to avoid either the perpetration of a fraud or an injustice. This usually means showing that the SMLLC owner was intentionally using the company to lie to someone or otherwise harm someone.
It's important to understand that both factors—unity of interest and fraud or injustice—need to be present in order for the SMLLC member to lose limited liability protection. Unity of interest, alone, without fraud or injustice, generally would not allow someone with a judgment against an SMLLC to gain access to the member's personal assets.
It's also important to understand that an owner choosing to organize a business as an SMLLC in order to gain protection from personal liability, by itself, is not a reason for a court to pierce the limited liability company veil. On the contrary, the general desire of a business owner to gain this protection—so long as it's not abused—is a primary reason why LLCs exist as a business form.
Other articles in the SMLLC section of this website cover matters such as how to clearly distinguish yourself from your business and how a personal creditor might be able to go after your SMLLC's assets. In addition, you can get the full picture of how to create and operate an SMLLC by picking up a copy of Nolo's Guide to Single-Member LLCs: How to Form and Run Your Single-Member Limited Liability Company by David M. Steingold (Nolo).