While visiting the Starting Out Forum here on BiggerPockets, I read through a thread titled “LLC Controversy”. Instead of responding to the thread directly, I decided to write this blog to address a fundamental issue for every investor, myself included: Why even bother setting up a business entity if my assets will be attached from a lawsuit arising from the acts of the business?
This thread started because of some erroneous information that was posted on another, very well known website, regarding business entities. I am absolutely astonished at the level of incorrect information that circulates to investors from various websites regarding business entities. Most often this misinformation is advanced by a gurus to steer you into to their complex webs of trusts and business entities. Let’s set the record straight:
It is extremely difficult to lose liability protection of your business if you follow a few simple rules.
Types of Liability Exposure
Before we delve into how you could potentially lose liability protection, it is important to understand the two different types of liability exposure when dealing with businesses and owners: Outside Liability and Inside Liability.
- Outside Liability refers to injuries (personal and financial) that occur in connection with the owners of the business personally and have no direct connection to the business activities. Example: I get into a car accident on my way home from work, this accident had no direct connection to the fact that I own several LLCs.
- Inside Liability refers to injuries (personal and financial) that occur within the business activity. As investors, the most common form of inside liability we are likely to see is if a tenant is injured on the property.
The level of protection your business assets receive if you, as the owner of the business, are sued (outside liability) depends solely on the laws of the state in which you are conducting business. Whether or not your separate business assets will be subject to attachment in a personal lawsuit is dependent on whether a charging order is the exclusive remedy for judgment creditors in that state.
Piercing the Veil
The main focus of this blog is whether or not you as the owner will be personally protected if the business is sued based on inside liability. Holding the owners of the business personally liable for injuries associated with the business is known as Piercing the Veil. The laws in all 50 states actively encourage formal business activity as a way to stimulate the local and state economy by encouraging businesses to conduct activities in their jurisdictions, albeit there are certainly more favorable states to conduct business activity. Even in the most pro-creditor states (i.e. California), businesses are still formed and operated because laws are designed to create a vehicle for business owners to remove themselves from personal liability exposure based upon the activities of their formal business structures. Here’s the relevant section of the California Corporations Code relating to LLCs:
17158. (a) No person who is a manager or officer or both a manager and officer of a limited liability company shall be personally liable under any judgment of a court, or in any other manner, for any debt, obligation, or liability of the limited liability company, whether that liability or obligation arises in contract, tort, or otherwise, solely by reason of being a manager or officer or both a manager and officer of the limited liability company.
As you can see, there is not automatic liability exposure for the owner of the LLC simply because that person is also a manager. The contrary is true; courts go out of their way to respect the separate existence of the business entity provided that the owner of the company followed a few necessary rules:
- The business was not undercapitalized.
- The formal requirements of the business were followed.
- The owner did not use the business as his or her alter ego.
- The owner did not use the business to perpetrate fraud.
Courts allow for the pierce of the veil as a matter of equity when the aforementioned conditions are not followed.
The Business is Undercapitalized
Undercapitalization simply refers to the business not having enough money or assets. Most states do not require a set amount to be contributed into the business account when the business is formed. Additionally, most courts do not have a bright line rule when determining whether or not there are sufficient assets within the business to satisfy its obligations. The main factor that is always addressed when determining whether or not a business is undercapitalized is the liabilities associated with the business activities.
In order for your business to be respected as a separate business entity, you must operate your business in a reasonably prudent manner. What is reasonably prudent capitalization when we are dealing with our companies that hold our investment properties? There should be sufficient funds in the business account to cover ordinary and necessary expenses associated with maintaining the business’s investments. This does not mean that we can’t put more money into our company to cover a major expense such as having to replace a roof. The business must hold funds to cover costs that arise in the course of regular business activity.
The one way I have seen courts pierce the veil when dealing with real estate investments due to undercapitalization occurs when the business owner cancels the insurance coverage on the property once it is transferred into the business entity. We cannot use our businesses as a substitute for insurance and vice versa. If a tenant is injured on the property it would not be viewed as reasonably prudent to hold assets with potential liability exposure without having the necessary insurance to cover the potential harms. This is a prime example of the court finding that it would inequitable for the owner of the business to escape liability exposure for harms that could be reasonably anticipated and easily insured against.
Failure to Follow the Formal Requirements
Each business has its own formal requirements that must be met in order for it to be respected under the laws of the state and to be allowed to avail itself to the protections offered by the state. As an owner of a business, you are going to have to comply with the formal requirements of the business entity that you have created.
- Corporations: Corporations generally will have the largest number of formal requirements. In almost every state at a bare minimum the following requirements must occur upon its creation and on an annual basis.
- LLCs are generally less cumbersome and can generally dispense with the meeting requirements of the corporation. However, it will be the Operating Agreement of the LLC that dictates what requirements must be met, if your Operating Agreement states you have to have at least an annual meeting, you better have the annual meeting. Unless stated otherwise in the Operating Agreement ,generally all that will need to be done with the LLC is:
o File Articles of Organization with the State
o Maintain the business in “good standing” with the Secretary of State by filing Annual Reports
It is extremely important to follow the necessary documentation requirements because it is this documentation that will serve to protect you from having the courts pierce the veil and hold you personally liable.
o File Articles of Incorporation with the State
o Organizational Meeting (minutes must be taken)
o Initial and then Annual Shareholders Meeting (minutes must be taken)
o Initial and then Annual Directors Meeting (minutes must be taken)
o Maintain the business in “good standing” with the Secretary of State by filing Annual Reports
Alter Ego Doctrine
Business entities provide protection because they are a separate legal entity from the owner. The Alter Ego doctrine states that the separate nature of the business will not be respected if the owner used the business as an extension of his or herself (alter ego). As a business owner you must treat the business separately from you. This means that you must hold yourself out as an agent of the company and never act in a personal capacity.
You can accomplish this by conducting all business transactions under the name of the company and having your tenants pay rent to the name of company, not you personally. Do not use business funds for personal expenses such as groceries or diapers. Have a separate bank account for the business and pay for business expenses out of that account. Basically, treat your relationship with the business as you would if you worked for someone else’s company. Remember that just because you own the business doesn’t mean you personally own the assets inside of the business.
Piercing the veil is an equitable doctrine to make the injured party whole and a fair remedy will always arise if the business owner uses the business to commit fraud or even acts grossly negligent. We cannot use a business as a shield for our bad acts. I once had a consultation with a contractor who was being sued personally because he spent all of the deposits for upcoming jobs to cover the expenses of the current jobs. When the money ran out the company defaulted on performing the jobs that deposits were already collected. This is a common occurrence in many industries. The contractor could not understand why he was going to face personal liability exposure. Before I sent him out the door, he learned the lesson that you can’t rely on the protection of the business entity to defraud the public.
Tying it all together
There are many factors we have to keep in mind when we are running a business. Maybe I should revise my initial question to: Why even bother setting up a business? Luckily, that is a short and simple answer: Having a business is the most tested and true method to protect you personally from being wiped out financially for harms arising from the business. Courts truly are reluctant to ignore the separate nature of the business unless the business owner forces their hand.
It is really quite simple to preserve your protection: Run the business like a business; Keep up on the paperwork; Keep business and personal assets separate and; Don’t rip people off and then look to the courts for protection. You may be asking: Then why was this blog so long? Simple, I’m an attorney and I get paid by the word.