One key reason that business owners choose the limited liability company (LLC) as the legal entity for their businesses is for the liability protection it affords. The owner of the business is then protected against being held personally liable for business debts or judgments made against the business. It is possible, however, for the courts to "pierce the veil of limited liability" of the LLC and hold the owners personally liable for business debts.
An LLC is a legal entity separate from the people (called members) who own it. As such, the members must be careful to respect the distinction between the LLC and their personal affairs. Unfortunately, smaller and closely-held LLCs (those owned by only one or a few people) are those most likely to have their veil pierced by the courts. If a piercing event were to happen, then creditors (or the courts) could target the owners' homes, personal bank accounts, investments and other assets to satisfy the business debts (not withstanding other available protections through bankruptcy and state law), which defeats the purpose of forming an LLC in the first place.
One such example of the courts finding that an LLC was merely an "alter ego" of the owner is the 2012 Colorado case Martin v. Freeman. In this case, Tradewinds Group, LLC, a single-member limited liability company, unable to pay a $36,600 judgment, had the LLC veil pierced and Freeman was found personally liable for the cost award. Some reasons cited for this included:
- Tradewinds assets were commingled with Freeman's personal assets;
- Tradewinds maintained negligible entity records and legal formalities were disregarded;
- Tradewinds' substantive transaction records were inadequate;
- Freeman paid Tradewinds' debts without characterizing the transactions;
- Tradewinds' assets were used for nonentity purposes;
- Proceeds of the sale of Tradewinds' assets were diverted to Freeman's personal account.
If operating under the assumption that the business owner isn't acting fraudulently and is observing the state requirements of maintenance for the LLC, then the main reason that a court would pierce the corporate veil of the LLC is if the court deems there to be no separation between the legal entity and the owner(s). The court can do this even without any evidence of fraud, bad faith, or wrongful intent.
The American Bar Association notes that one of the best ways to maintain this distinction between business owner and the business entity is to avoid running personal expenses through the business accounts, and to use business assets only for business purposes. When assets from the business are needed for personal use, make sure that those "distributions" are made appropriately and with transparency. Additionally, all company business should be conducted in the name of the business (not the owner), and company books, records and financial statements should be maintained clearly to reflect the separation between the business entity and the personal assets of the members. When a member signs documents or correspondence on behalf of the LLC, the LLC's name should always be included in the signature block.
Some common examples of commingling assets of the business with personal assets include:
- Depositing checks made payable to the business into the owner's personal bank account;
- Paying personal bills from the business accounts;
- Maintaining business checking, savings and credit accounts in the name or SSN of the owner;
- Using the business credit card for personal expenses and purchases;
- Diverting business assets for personal use.
To be clear, accidentally grabbing the business credit card one day at lunch is not cause for alarm, as the occasional personal transaction can still be recorded appropriately on the business books. However, if the personal expenses are routinely run through the business accounts (even if they are recorded appropriately), it is more likely that ALL expenses will come under scrutiny. Should the court deem that the owner isn't even attempting to keep the business entity separate, personal assets could be at risk.