Protecting the Corporate Veil

An important reason for using an LLC in the U.S. is its heightened protection against judgment creditors. In a general corporation, formalities must be strictly followed or creditors can destroy the protection from personal liability by “piercing the corporate veil”.

This happens most often in situations where the shareholders of a corporation disregard the legal separateness of the corporation and the corporation acts as nothing more than an alter ego for the shareholders’ own dealings.

Most of the necessary formalities, such as stockholders and directors meetings, minutes, officers and director elections can thankfully be eliminated in an LLC. Judgment creditors of a member of an LLC also cannot seize control of the assets of the LLC, or the member’s voting rights, as they may be able to with a corporation.

In addition, Delaware-based LLCs enjoy further protection from the fact that since company ownership and management is not necessarily public information in the first place, it is that much more difficult for creditors and litigators to pierce the corporate veil.

Nevertheless, I encourage you to take your ownership and management responsibilities seriously and treat your LLC as a separate and distinct entity. Give thought to the following general guidelines, which imply not only good business sense, but if followed help guarantee the sanctity of your corporate veil:

• Hold an organizational meeting. After the formation of the LLC is complete, the members or managers should hold a formal meeting to adopt an operating agreement and issue membership interest to members.
• Adopt an operating agreement. As with the corporate bylaws, the operating agreement for an LLC is an important document that outlines the internal governance of the LLC.
• Establish a clear and separate identity for the LLC apart from its constituent members (including a separate office, stationery, books, and assets).
• Keep documentation of the LLC’s activity. It is typically considered beneficial to keep record of any changes in membership interest and also to keep record of all major business decisions of the LLC, such as contracts and leases.
• Keep documentation of financial activity. Use accounting software or bookkeeping companies to keep track of your LLC’s incomes and expenses. LLCs should maintain the pretty much the same financial information as corporations:
  • Record all disbursements, payments received, invoices issued (accounts receivable), and invoices received (accounts payable), and keep those records for a period of 7 years.
  • Keep balance sheets and profit and loss statements for each year.
  • Additionally, it’s important to document any loans taken by the LLC, as well as the repayment terms.
• Operate your LLC and manage its cash and other assets at arm’s length, like the distinct entity it is:
  • Do not commingle the owners’ or members’ personal assets with the assets of the business.
  • Always identify your business as an LLC.
  • Conduct business on the LLC’s behalf: members should visibly be acting on behalf of, and in the best interest of the LLC. This is important when it comes to members entering into contracts for the LLC.
  • Do not personally endorse public documents. Clearly designate the LLC as the entity entering into and executing (and solely authorized to enter into and execute) business agreements and contracts intended to bind and benefit the LLC.
• Hold annual meetings of members. Holding and documenting the business conducted at annual meetings of the members or managers helps LLCs keep updated ongoing records of decisions made by the owners.
• Keep your LLC in good standing with the state:
  • File annual statements and pay the necessary fees in a timely manner.
• Don’t dare a party dealing with the LLC to sue it by asserting, e.g., that “the LLC doesn’t have any money or assets you can reach, and that’s the reason we formed it.”
• Comply with all of the governmental reporting requirements with respect to payroll, sales and federal income tax.
• Do not engage in activities with the intent to defraud creditors or permit members to engage in illegal, fraudulent and/or negligent acts (duh!)
• Most importantly, seek legal counsel if you are confused or unsure about whether you are in compliance with the elements discussed above!

In addition to maintaining separation between owners or members and the LLC: In examining the separate existence of a subsidiary company or sister corporation, the courts will look to see if one entity tends to dominate the actions of the other so that the latter might be fairly characterized as a “mere instrumentality” or department of the former.

Naturally, the likelihood of such a finding will be increased if the “subservient” entity has been given inadequate operating assets or if its creditors have been led to believe that they are dealing with the dominant entity. The courts will also inquire into the following factors:

• Whether the two entities have common beneficial owners and members.
• Whether the entities have observed separation in the maintenance of corporate and financial records.
• Whether the officers of the subservient entity actually take orders from the entity’s members or from the officers of the dominant entity.
• Whether the dominant entity exercises fiscal control over the subservient entity by maintaining the assets necessary for the conduct of the subservient entity’s business or by actually paying its operating salaries and expenses.
• Whether transactions between the two entities are conducted on an arms-length and non-favored basis.
• Whether the public statements issued by the entities are consistent with the claim of a separate existence.