Limited Liability for LLCs; Is it an Urban Legend?

J. Marc Ward¹ Krista K. Tanner²

Limited Liability Companies (LLCs) have quickly become the business entity of choice since they became widely available in the mid-1990''s. The LLC''s hybrid status that provides entities with the limited liability of corporations and the single-tier taxation of partnerships has made it an attractive entity for many businesses. Recently, however, a curious and disturbing trend has surfaced. There is a presumption among many businesspersons that LLCs really do not provide protection from liability for its owners. Call it an urban legend. The truth is, except in certain cases involving the non-payment of taxes, LLCs provide the same protection from liability for its owners as a corporation does for its shareholders.

Although, the concept of LLCs is relatively new, cases to date involving LLC liability indicate that limited liability will be extended to members of LLCs. However, as in the corporate context this is not absolute limited liability. Members of LLCs may be held personally liable under the traditional corporate veil piercing context which involves undercapitalization, commingling of corporate funds, and holding out to be personally liable. Members of LLCs may also be personally liable for failing to dissolve the LLC according to statute and under an agency theory when they do not disclose to the creditor that the LLC is the contracting party.

There are three kinds of liability that should concern the owner of a business; contractual liability; tort liability; and tax liability.

Contractual and Tort Liability

As a general rule a member or manager of an LLC is not personally liable for the contractual or tort liabilities of an LLC by reason of being a member or manager of an LLC. Members and managers remain responsible for their own acts and for activities undertaken in an individual capacity on behalf of the LLC (such as loan guaranties) as well as for the performance of their contractual undertakings with the LLC (such as capital contributions). Members and managers also are not relieved of liability otherwise imposed by law (such as the liability of "responsible persons" for unpaid taxes). As a corollary to the general limitation of liability, a member of an LLC is not a proper party to a proceeding by or against a limited liability company, except in connection with a derivative action or in a case involving the enforcement of a member''s right against or liability to the LLC.

Generally, members of an LLC can be held liable for the contractual and tort liabilities of the LLC under the following circumstances:

Liability for contributions. Members of LLCs are generally liable to the LLC for any promised contributions. In addition, a member is generally liable to a creditor for failure to make a required contribution if the creditor extended credit to the LLC in reliance on the expected contribution of the member.³ A member cannot extinguish this obligation to make a required contribution by assigning his or her membership interest to another person.⁴ In fact, in most cases, if the assignee becomes a member of the LLC the assignee will also be responsible for the contributions of an assignor that were known to the assignee.⁵

Liability for Distributions. Members of an LLC may also be liable for distributions that are wrongfully made either while the LLC is a going concern or as a result of the dissolution and winding up of the LLC. A wrongful distribution during the life of the LLC will occur if the distribution either caused the LLC to be unable to pay its debts as they come due or resulted in the liabilities of the LLC to exceed its assets. Liability resulting from the receipt of a distribution as a result of the dissolution of the LLC will usually accrue if the member had knowledge that creditors were still unpaid or if the claim was unknown as of the time of the distribution.⁶

Piercing the LLC Veil. It also seems clear now that most courts will apply the common doctrine of piercing the corporate veil to LLC members to determine if members should be personally liable for the obligations of the LLC. Some states, such as Coloraldo, address the issue in the LLC enabling legislation. The Colorado statute mandates that courts are to apply corporate case law to LLCs when determining the circumstances when the liability veil of an LLC will be pierced and the members will be personally liable.⁷ Other states, such as Minnesota, North Dakota and Illinois have enacted statutes that follow a similar line.⁸

The California statute provides that a member is personally liable to the same extent a shareholder of a corporation may be personally liable for any debt, obligation or liability of the corporation. The California LLC act does note, however, that the failure to hold meetings or otherwise observe formalities relating to the calling or conducting of a meeting are not factors in establishing the personal liability of a member in cases "where the articles of organization or operating agreement do not expressly require the holding of meetings of members or managers."⁹ On first blush, this exception would appear to be beneficial to members of LLCs, but stated another way the statutory provision takes on a more ominous tone. That is, if the articles of organization or operating agreement require the holding of meetings of members or managers, then the failure to hold such meetings or otherwise observe formalities attendant to such meetings is a factor to be considered in establishing the personal liability of a member.

The absence of a statute to providing guidance regarding LLC member liability does not relieve an LLC member from personal liability. Most courts seem willing to apply corporate veil piercing principles to controversies involving LLC member liability regardless of whether the jurisdictional state has enacted legislation directing courts to do so.¹⁰ Therefore, an analysis of LLC member liability necessarily begins with a discussion of law regarding piercing the veil of a corporation and the circumstances when corporate shareholders will be found liable for the corporation''s debts and obligations.

One commonly referred to doctrine is the "alter ego" doctrine. "[W]hen the corporation is the mere alter ego, or business conduit of a person, it may be disregarded."¹¹ The doctrine of alter ego fastens liability on the individual who uses a corporation merely as an instrumentality to conduct his or her own personal business, and such liability arises from fraud or injustice perpetrated not on the corporation by on third persons dealing with the corporation.

In order to disregard the corporate entity under the alter ego doctrine, two circumstances must be shown: "(1) Such a unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist, but the corporation is, instead, the alter ego of one or a few individuals; and (2) if observed, the corporate form would result in an inequity."¹²

The rationale of applying the alter ego theory is that "if the shareholders themselves, or the corporations themselves, disregard the legal separation, distinct properties, or proper formalities of the different corporate enterprises, then the law will likewise disregard them so far as is necessary to protect individual and corporate creditors."¹³

A second doctrine often discussed by courts when disregarding the corporate entity is the "instrumentality" doctrine.¹⁴ According to this doctrine, courts will disregard the separate legal entity when a corporation "is a mere instrumentality or agent of another corporation or individual owning all or most of its stock."¹⁵ The instrumentality doctrine require proof of three elements: (1) complete domination and control, not only of finances but also of policy and business practices with respect to the transaction which caused the damages that at the time of the transaction the corporation had no will or existence of its own; (2) the control must have been used to commit fraud, perpetrate a violation of statute or legal duty, or a dishonest or unjust act; and (3) the control and breach of duty must have proximately caused the injury and unjust loss of the plaintiff.¹⁶

Despite these doctrines and their different labels and formulations, "the doctrines are essentially the same and most courts generally regard the doctrines as interchangeable."¹⁷ The heart of the issue is whether shareholders and officers of a corporation conducted their private and corporate business in such a way that to not pierce the corporate veil would in some way work an injustice.¹⁸

Most courts use some type of combination of theories in order to justify piercing the corporate veil.¹⁹ There are no strict guidelines in determining whether to disregard the corporate entity. Instead, each case is "sui generis and must be decided in accordance with its own underlying facts."²⁰ Courts look to the totality of the circumstances when deciding whether to pierce the corporate veil.²¹ Although the circumstances and factors which are considered significant in concluding to pierce the corporate veil "have been rarely articulated with any clarity,"²² several factors have been adopted by courts to aid in their decision. These factors are regarded as guidelines and not as a conclusive test.²³

The following factors are often listed by courts in aiding their decision to pierce the corporate veil:

1. Inadequate capitalization.²⁴ "An obvious inadequacy of capital, measured by the nature and magnitude of the corporate undertaking, has frequently been an important factor in cases denying stockholders their defense of limited liability."²⁵
   
   
2. Failure to follow corporate formalities.²⁶ Corporate formalities include: holding board meetings and shareholder meetings, including elections; keeping minutes and corporate records;²⁷ and issuing stock.²⁸ The shareholders must have treated the corporation as if it were an independent entity.
   
   
3. Nonpayment of dividends.²⁹ If the corporation does not pay dividends to its stockholders, even though the corporation appears to be making a significant profit, the court may view that factor as significant.
   
   
4. Siphoning of funds of the corporation by the dominant stockholder.³⁰ Related to under-capitalization is evidence of "draining" or "siphoning" the earnings and profits of the corporation for personal use. The more the dominant stockholder appears to be in control of the fiscal matters of the corporation, the more the corporation appears to be a sham, therefore mandating the piercing of the corporate veil.
   
   
5. Use of the corporation as a facade for personal business. If the corporation is a mere dummy for its individual stockholder who are carrying on the business for their personal gain instead of for corporate gain, the court may pierce the corporate veil. In determining if the corporation is a facade, commingling of corporate and personal assets, the use of corporate funds to pay personal expenses without proper accounting, and the failure to maintain complete corporate and financial records are looked upon with extreme disfavor.³¹
   
   
6. Non-functioning of other officers or directors.³²
   
   
7. Use of the corporate entity in promoting injustice or fraud.³³

When the corporation is formed to perpetrate a fraud or to conceal illegality, a court will ordinarily pierce the corporate veil.³⁴ Proof of fraud is not a necessary element in a finding to disregard a corporate entity,³⁵ however if actual or constructive fraud is shown, it may be sufficient to pierce the corporate veil. In some jurisdictions fraud or injustice must result from an abuse of the corporate form; an injustice that results from ancillary activity is not sufficient basis for disregard of the corporate entity. Some courts have referred to a requirement of intentional misconduct, while others reiterate the boilerplate requirement that there must be some form of deception, injustice, defeat of public policy, or fraudulent, improper, or criminal purpose.

The conclusion to disregard the corporate entity may not, however, rest on a single factor, whether under-capitalization or the disregard of corporation''s formalities. Instead, the decision must rest on a number such factors; in addition, the case must present an element of injustice or fundamental unfairness.³⁶

Liability of Members under Agency Principles. An LLC member may also be found to liable to third parties under the principles of agency law. Under the common law doctrine of agency, an agent is liable on a contract entered on behalf of a principal if the agent does not disclose both that he or she is acting on behalf of a principal and the identity of the principal. In Water, Waste & Land, Inc. v. Lanham, an LLC member failed to disclose the existence and the name of the LLC to a creditor and the creditor believed he was contracting with the member personally. As a result, the court imposed personal liability on the LLC member based on the principals of agency law.

Tax Liability

Single Member LLC Tax Liability. The LLC''s hybrid status presents unique issues for single member LLCs in the federal tax liability context. Unlike issues relating to contractual and tort liability, a single member LLC can not look to corporate case law for guidance in tax issues if it has elected to be disregarded as an entity separate from its owner. For federal tax purposes, if a single member LLC is disregarded, its activities are treated in the same manner as a sole proprietorship.³⁷

For example, in the employment tax context, the IRS allows single member LLCs to separately calculate, report and pay its employment tax obligations under the LLC name and Employment Identification Number (EIN).³⁸ The IRS makes it clear, however, that reporting employment tax obligations under the name and EIN of the LLC does not resolve the member from the employment tax liability.³⁹ As a result, the single member owner of the LLC "retains ultimate responsibility for the employment tax obligations incurred with respect to the employees of the disregarded entity."⁴⁰

LLC Liability for Member Obligations. As discussed above, when a single member LLC elects to be a disregarded entity, the IRS treats the activities of the LLC in the same manner as a sole proprietorship for tax purposes. As a result, a single member is responsible for the tax responsibilities of the LLC. This rule has left many LLCs wondering if, because the single member is responsible for the LLCs tax obligations, the opposite is also true. That is, can the single member LLC be required to satisfy the personal tax obligations of its only member?

In a 1999 Memorandum, the Internal Revenue Service issued its policy regarding the IRS''s ability to place a lien against the assets of a one-member LLC to satisfy the tax liability of that taxpayer.⁴¹ The IRS held that the mere fact the LLC entity is disregarded for federal tax purposes does not entitle the IRS to disregard the entity for the purposes of collection. Sections 6321 and 6331 of the Internal Revenue Code authorizes the IRS to create a lien against all property belonging to an individual owing taxes to the IRS. However, because LLCs are separate entities from its members under state law, individual taxpayers do not have any property interests in the property of the LLC. Therefore, the IRS could not serve a levy against the property of the LLC because it does not belong to the taxpayer.

Despite its finding that the IRS could not reach the assets of the LLC to collect taxes owed to the IRS by the LLC members, the IRS opined that it was not without other collection options. The IRS reasoned that if the taxpayer has a transferable distributional interest in the LLC pursuant to state statute, the IRS can place a lien on the interest. In addition, if grounds for piercing the LLC veil exist, the IRS can collect from the LLC as the alter ego of the single member taxpayer.

Conclusion

With the exception of certain federal tax liabilities, the treatment of LLC members the last ten years is consistent with the treatment afforded corporation shareholders. Courts recognize that LLCs are separate entities from its owners and have been reluctant to hold members liable for the obligations of the LLC. Thus, the notion that LLCs provide less protection from personal liability than corporations is an urban legend, nothing more.



¹ Mr. Ward is a shareholder at the firm of Dickinson, Mackaman, Tyler & Hagen.

² Ms. Tanner is an associate in the firm of Dickinson, Mackaman, Tyler & Hagen.

³. See, generally, CAL. CORP. CODE '' 17201 (b) (___); DEL. CODE ANN. tit. 18 ‘ 502(b) (___); FLA. STAT. CH. 608.435(3) (___); MO. REV. STAT. ‘ 7359.755 (c) (__) (McKinney ___); and TEX. REV. CIV. STAT. ANN. ART. 1528n ‘ 5.02(d) (West ___).

⁴. See, for example, CAL. CORP. CODE '' 17303(c) (___); DEL. CODE ANN. tit. 18 '' 704(c) (___); ILL. REV. STAT. Ch. 805 para. 180 30-15-___ (___); N.Y. Law '' ___-605 (McKinney___); and TEX. REV. CIV. STAT. ANN. ART. 1528n '' 4.07 (c) (West _).

⁵. See, for example, CAL. CORP. CODE '' 17303(b) (___); DEL. CODE ANN. tit. 18 '' 704(b) (___) ILL. REV. STAT. Ch. 805 para. 180 30-15 (___); N.Y. ___ Law ''___-604 (McKinney___); and (WEST ___).

⁶. See New Horizons Supply Cooperative v. Haack, 1999 WL 33499(Wis. App. Jan. 28,1999); see also, for example, CAL. CORP. CODE " 17254(e) and 17355(a)(1)(B) (___); DEL. CODE ANN. TIT. 18 '' 607(b) (___); ILL. REV. STAT. Ch. 805 para. 180 25-25 (___); N.Y. ___ Law '' ___-508(b) (McKinney___); R.I. GEN. LAWS '' 7-16-32 (___); and TEX. REV. CIV. STAT. ANN. ART. 1528n ''5.09(B) (West___).

⁷ COLO. REV. STAT. ''7-80-107 (Supp. 1990).

⁸. MINN. STAT. ANN. § 322B.303(2) (___); N.D. CENT. CODE § 10-32-29(3) (___); ILL. REV. STAT. Ch. 805 para. 180, 10-10; see also Tom Thumb Food Markets Inc. v. TLH Property, No. C9-98-1277, 1999 WL 31168 (Minn. App. Jan.26, 1999).

⁹. Id.

¹⁰ See Hollowell v. Orleans Regional Hospital, 217 F.3d 379, 385-88 (5th Cir. 2000); Ditty v. Checkrite, 973 F. Supp. 1320, 1335-36 (D. Utah 1997); Hamilton v. AAI Ventures, 768 So.2d 298 (La. Ct. App. 2000); People v. Garban, 1999 WL 496182 (N.Y. Sup. Ct. June 17, 1999).

¹¹. See 1 W. Fletcher, Cyclopedia of the Law of Private Corporations §41.10 (Perm. Ed.).

¹². Coleman 743 P.2d at 786.

¹³. 1 W. Fletcher, supra §4 1. 10 at 614.

¹⁴. This doctrine is also sometimes referred to as the "identity" doctrine. See Zaist v. Olson, 227 A.2d 552, 558 (Conn. 1967).

¹⁵. Zaist, 227 A.2d at 557.

¹⁶. Id. at 558; Krivo Industrial Supply Co., 483 F.2d at 1103.

¹⁷. P. BLUMBERG, THE LAW OF CORPORATE GROUPS: SUBSTANTIVE LAw §6.01 (1987).

¹⁸. See e.g.; Kwick Set Components, Inc. v. Davidson Industries, Inc., 411 So. 2d 134 (Ala. 1982).

¹⁹. See e.g.; Dewitt Truck Brokers, 540 F.2d at 685. (when substantial ownership of all of the stock of a corporation by a single individual is combined with other factors clearly supporting disregarding the corporate fiction on the grounds of equity and fairness, courts have experienced little difficulty in applying the "alter ego" or "instrumentality" theory in order to cast aside the corporate shield); Minton v. Cavaney, 364 P.2d 473 (Cal. 1961)("The figurative terminology ‘alter ego'' and ''disregard of the corporate entity'' is generally used to refer to the various situations that are an abuse of the corporate privilege. ")

²⁰. Brown Bros. Equipment Co. v. State, 215 N.W.2d 591, 593 (Mich. Ct. App. 1974).

²¹ . R. Keatinge, L. Ribstein, The Limited Liability Company: A Study of the Emerging Entity, 47 THE BUS. LAW. 375 (1992).

²². Dewitt TruckBrokers, 540 F.2d at 684, quoting Swanson v. Levy, 509 F.2d 859, 861-2 (9th Cir. 1975).

²³. Fletcher Cyc. Corp. §41.30 at 662 (Perm. Ed.).

²⁴. Refco, Inc. v. Farm Production Ass’n, Inc., 844 F. 2d 525 (8th Cir. 1988); Bergen v. F/V St. Patrick, 816 F.2d 1345 (9th Cir. 1987); J.L. Brock Builders, Inc. v. Dahlveck, 391 NW.2d 110 (Neb. 1986); and Lucas v. Texas Industries, Inc., 696 S.W.2d 372 (Tex. 1984).

²⁵. Anderson, 321 U.S. at 362. See also; Weisser v. Mursam Sboe Corp., 127 F.2d 344, 348 (2d Cir. 1942); and Pepper v. Litton, 308 U.S. 295, 310 (1939).

²⁶. See; Lakota Girl Scout C., Inc. v. Havey Fund Raising Mftg. Inc., 519 F.2d 634, 638 (8th Cir. 1975)(corporate formalities were not followed); Dewitt Truck Brokers 540 F. 2d at 686, nt. 14. (while disregard of corporate formalities is a circumstance to be considered, it is generally held to be insufficient in itself, without some other facts, to support a piercing of the corporate veil.) See also; Zubik v. Zubik, 384 F.2d 267, 271, nt.4 (3rd Cir. 1967) cert. denied. 390 U.S. 988 (1968)(in the context of an attempt by an outside party to pierce the corporate veil of such a closely-held corporation, the informalities are considered of little consequence.) But see; Harrison v. Puga, 480 P.2d 247, 254 (Wash. 1971)(since the defendants disregarded the corporate formalities, they could hardly complain if the court did likewise); and Colman 743 P.2d at 782.

²⁷. See; Bergen 816 F.2d at 1345; Brigg''s Transp. Co. Inc. v. Starr Sales Co. Inc., 262 N.W.2d 805 (Iowa 1978); and Coleman, 743 P.2d at 786.

²⁸. See generally, L.C. Di Stasi, Annotation, Failure to Issue Stock as Factor in Disregard of Corporate Entity, 8 A.L.R.3d 1122, 1126 (1966). See also; Laborers Clean-up Contract Administration Trust Fund v. Uriarte Clean-up Service, Inc., 736 F.2d 516 (9th Cir. 1984); C. Mac Chambers Co., Inc. v. Iowa Tae Kwon Do Academy, Inc., 412 N.W.2d 593 (Iowa 1987).

²⁹. Schoenberg v. Benner, 59 Cal. Rptr. 359 (Cal. App. 1967); Coleman, 743 P.2d at 782; and Bergen, 816 F.2d at 1345.

³⁰. Amoco Chemicals Corp. v. Bach, 567 P. 2d 13 37, 1341 (Kan. 1977); and Coleman, 743 P. 2d at 667.

³¹. Stillman v. Tempo Carpets, Inc., 329 S.E.2d 197, 198 (Ga. 1967); McCombs Const. Inc. v. Barnes, 645 P.2d 1131, 1135 (Wash. 1982); and Bergen 816 F.2d at 1345.

³². Refco Inc. v. Farm Production Ass’n, Inc., 844 F.2d 525 (8th Cir. 1988); and Colman, 743 P.2d at 782.

³³. See e.g.; Coleman, 743 P.2d at 786.

³⁴. See e.g.; Nebraska Engineering Co. v. Gerstner, 323 N.W.2d 84 (Neb. 1982); KwickSet Components, Inc., 411 So. 2d at 136 (the theory of separate existence can be disregarded, even in the absence of fraud, to prevent injustice or inequitable results).

³⁵. See; Anderson, 321 U.S. at 362. (The cases of fraud make up part of that exception [which allow the corporate veil to be pierced]. But they do not exhaust it.).

³⁶. FLETCHER CYC. CORP. §41.30 at 664 (Perm. Ed.).

³⁷ Treas. Reg. section 301.7701-2(a).

³⁸ Notice 99-6, 199-3 I.R.B. 12.

³⁹ Id.

⁴⁰ Id.

⁴¹ Gen. Couns. Mem. 199930013 (April 18, 1999).