Veil Piercing

Annual Meetings of Members of an Arizona LLC

Question:  Does Arizona limited liability company law require the members and managers of an Arizona LLC to hold an annual meeting?

Answer:  No.  However, some badly worded Operating Agreements do require that the members hold annual meetings.

Although no Arizona statute or case requires annual meetings or special meetings of the members or managers of an Arizona LLC as an Arizona LLC attorney who has formed 6,700+ Arizona LLCs I recommend that both types of meetings be held. There are two reasons why members and managers should hold meetings.

  • To reduce the chance that a court will pierce the veil and hold the members of the LLC liable for the debts of the LLC.  One of the factors courts consider when asked to pierce the veil is “did the LLC operate like a business or a hobby?”  Prudent businesses hold meetings and document the actions approved or rejected by the members and managers.  LLCs operated like a hobby do not hold meetings.  Note:  If your LLC’s Operating Agreement requires that the members or managers hold annual meetings then you must make sure that the meetings are actually held and document that fact.  The failure of members to hold annual meetings required in an Operating Agreement is a factor that counts against the members when a court is asked to pierce the veil and hold the members liable for the debts of the LLC.
  • To inform members and managers of important proposed company before it occurs and give them the opportunity to vote to approve or reject the proposed action.  This is especially important when an LLC has multiple unrelated members.  Consider two hypotheticals:  (1) LLC is considering whether to enter into a contract that will require the company to pay a third party a lot of money.  The member who owns more than 50% who is a manager signs the contract without prior notice to the other members who learn of the contract after it’s a done deal.  (2) Same facts, but majority member holds a meeting of the members at which all of the members discuss the proposed contract and then vote on whether or not to sign the contract.  The first method risks alienating the other members who will rightly feel left in the dark.  The second method gives everybody a chance to be informed in advance and give their two cents on signing or rejecting the contract.  Guess which method is less likely to result in disgruntled members who may want a company divorce.

Purchase My Do-It-Yourself Meeting Minutes & Resolutions

I’ve made it very easy for Arizona LLCs to document actions approved by members and managers. Just purchase my editable Word meeting minutes and resolutions that you can modify whenever needed to document special and annual meetings of your LLC’s members and managers.  You can also purchase a document called “Action by Consent” by which the members and managers can adopt resolutions approving company actions in lieu of actually holding a meeting. Each document comes with 16 resolutions for the most common types of actions voted on by members and managers.

Go to my Arizona legal form store to purchase your do-it-yourself minutes and resolutions.

2019-06-15T07:41:39-07:00December 6th, 2014|FAQs, Operating LLCs, Veil Piercing|0 Comments

What is Piercing the Veil of an LLC & Why is Do You Need to Understand It?

Question:  I have heard the term “piercing the veil” of a corporation or a limited liability company.  What does the term mean and why do owners of LLCs need to understand it?

Answer:  “Piercing the veil” means that a court disregards the shield or veil created by state law that says the owners of a corporation or an LLC are not liable for the debts of the entity.

Example 1: Homer Simpson’s LLC called World Wide Widgets, LLC, borrowed $25,000 from Ned Flanders.  The LLC signed the promissory note, but Homer didn’t.  The LLC does not pay.  World Wide Widgets, LLC, doesn’t have any assets so Ned knows if he gets a judgment against the LLC he can’t collect it.  Ned never gets his money.

Example 2:  Same facts as Example 1, but in operating the LLC Homer did not follow Arizona LLC law and did not follow proper procedures.  Ned sues the LLC and Homer and asks the court to pierce the veil and hold Homer liable for the LLC’s debt.  The court finds there are grounds to pierce the company veil and holds Homer personally liable for the LLC’s $25,000 debt.  This is the bad result for the LLC member and frustrates the reason people form an LLC, i.e., to protect themselves from liability for the debts of the LLC.

Jay Adkisson, a nationally known asset protection lawyer, said the following in response to a recent court ruling in a case called Shermane Hector v. Mo–Dad Environmental Serv., LLC:

The veil-piercing/alter ego challenges to LLCs are going to be interesting because they start out with the intended lack of formality of corporations, and then their owners often get loosey-goosey about how the company is operated, how it is capitalized (and continues to be capitalized), etc.  IMHO, the real challenge for planners is not so much in the meticulous drafting of LLC management agreements and the like, but in the education of owners as to how the entity needs to be run after all the ink dries.

How true.  The vast majority of people think that if they file the Arizona Corporation Commission’s fill in the blanks form Articles of Organization they are home free and their life savings are protected from the LLC’s debts.  Ignorance may be bliss, but ignorance of the legal concept called “piercing the company veil” can cost LLC members big bucks.

Most people who form an LLC don’t know that they must comply with Arizona’s LLC law or risk a court piercing the veil and holding them liable for the LLCs debts.  For example, Arizona LLC law requires that every Arizona LLC maintain certain records.  If you own an Arizona LLC don’t you think it would be a good idea to comply not only with that statute, but other Arizona LLC laws too?

The Shermane Hector v. Mo–Dad Environmental Serv., LLC court said this about veil piercing:

Some of the relevant factors considered in determining whether to apply the alter ego doctrine include: commingling of corporate and shareholder funds; failing to follow statutory formalities for incorporating and transacting corporate affairs; undercapitalization; failing to maintain separate bank accounts and bookkeeping records; and failing to hold regular shareholder and director meetings”

In forming 6,700+ Arizona LLCs I learned a long time ago that I must educate my LLC clients about Arizona LLC law.  I accomplish this two ways:

  • The LLC Operations Manual:  This is a 170 page book I wrote that explains Arizona’s LLC law in great detail.  For example, chapter 3 of the Operations Manual contains a list of 34 tasks that every LLC should complete in its first 75 days.  Learn more about the LLC Operations Manual.
  • Informative Email Messages:  Everybody who hires me to form an Arizona LLC will be sent 50 email messages during the first year informing them about Arizona LLC law and reminding them to do things like sign the Operating Agreement, open a bank account, set up the LLC’s bookkeeping system, consult with a CPA and document loans by members to the LLC.

To learn more about this very important topic read my article called “Two Phases in the Life of an LLC.”

Abolishing LLC Veil Piercing

University of California, Los Angeles (UCLA) – School of Law Proffessor Stephen M. Bainbridge wrote a great article called “Abolishing LLC Veil Piercing.”  The abstract says:

 “Courts are now routinely applying the corporate law doctrine of veil piercing to limited liability companies. This extension of a seriously flawed doctrine into a new arena is not required by statute and is unsupportable as a matter of policy. The standards by which veil piercing is effected are vague, leaving judges great discretion. The result has been uncertainty and lack of predictability, increasing transaction costs for small businesses. At the same time, however, there is no evidence that veil piercing has been rigorously applied to affect socially beneficial policy outcomes. Judges typically seem to be concerned more with the facts and equities of the specific case at bar than with the implications of personal shareholder liability for society at large.

 A standard academic move treats veil piercing as a safety valve allowing courts to address cases in which the externalities associated with limited liability seem excessive. In doing so, veil piercing is called upon to achieve such lofty goals as leading LLC members to optimally internalize risk, while not deterring capital formation and economic growth, while promoting populist notions of economic democracy. The task is untenable. Veil piercing is rare, unprincipled, and arbitrary. Abolishing veil piercing would refocus judicial analysis on the appropriate question – did the defendant – LLC member do anything for which he or she should be held directly liable.

2016-11-16T08:23:46-07:00April 21st, 2012|Asset Protection, Veil Piercing|0 Comments

Colorado Court Pierces LLC Veil & Holds Single Member Liable for LLC’s Debt

When On February 2, 2012, the Colorado Court of Appeals issued its opinion in the case of Martin vs. Freeman, a case that is important for all limited liability company owners who want to avoid becoming liable for the debts of their LLC.

The Facts

Dean C.B. Freeman was the sole member and manager of Tradewinds Group, LLC, a Colorado limited liability company.  Tradewinds only asset was an airplane that it owed free and clear with a value of approximately $300,000.  Tradewinds hired Robert L. Martin to build an airplane hangar for its airplane. Tradewinds sued Martin in 2006 for breach of the construction  contract. In 2007 Tradewinds sold the airplane for $300,000.  After making sure that all creditors were paid Freeman caused the LLC to pay him all funds that remained in the LLC’s bank account.  Thereafter Freeman paid all of Tradewinds’ litigation expenses from his funds.

In 2008, the trial court entered a judgment in favor of Tradewinds. Martin appealed and won the appeal. The Colorado Court of Appeals found that Tradewinds’ damages were speculative and sent the case back to the trial court with directions to enter judgment in favor of Martin. The trial court ruled in 2010 that Martin was the prevailing party and awarded him $36,645.40 in costs.

 When Martin won the $36,645 judgment against Tradewinds Group, LLC, it did not have any because it had sold its only asset and paid all of the company’s funds to its sole member, Dean Freeman. Martin then sued to pierce the LLC veil and collect Tradewinds’ debt from Freeman, the sole member of the LLC.

The primary issue before the Colorado Court of Appeals was should the court allow Martin to pierce the LLC’s veil and hold its sole member liable for Martin’s judgment against Tradewinds Group, LLC? The appellate court stated:

“To pierce the LLC veil, the court must conclude

  1. the corporate entity is an alter ego or mere instrumentality;
  2. the corporate form was used to perpetrate a fraud or defeat a rightful claim; and
  3. an equitable result would be achieved by disregarding the corporate form.”

The Colorado Court of Appeals in a two to one decision ruled that all three criteria existed and that Dean C.B. Freeman was personally obligated to pay the judgment owed to Robert L. Martin.

1st Factor:  Alter Ego

The majority’s opinion says that courts consider a variety of factors in determining alter ego status, including whether:

  1. “the entity is operated as a distinct business entity;
  2. funds and assets are commingled;
  3. adequate corporate records are maintained;
  4. the nature and form of the entity’s ownership and control facilitate insider misuse;
  5. the business is thinly capitalized;
  6. the entity is used as a mere shell;
  7. legal formalities are disregarded; and
  8. entity funds or assets are used for non-entity purposes.”

The Court does not, however, tell us if alter ego status exists if a majority of the factors exist or if all all of the factors must exist or it is is merely a gut feeling determined by the court that sufficient factors exist to justify a finding that the company was the alter ego of the member.  The Court found the following facts that justified its conclusion Tradewinds was Freeman’s alter ego:

  • “Tradewinds’ assets were commingled with Freeman’s personal assets and the assets of one of his other entities, Aircraft Storage LLC;
  •  Tradewinds maintained negligible corporate records;
  •  the records concerning Tradewinds’ substantive transactions were inadequate;
  •  the fact that a single individual served as the entity’s sole member and manager facilitated misuse;
  •  the entity was thinly capitalized;
  •  undocumented infusions of cash were required to pay all of Tradewinds’ operating expenses, including its litigation expenses;
  •  Tradewinds was never operated as an active business; legal formalities were disregarded;
  •  Freeman paid Tradewinds’ debts without characterizing the transactions;
  •  Tradewinds’ assets, including the airplane, were used for non­entity purposes in that the plane was used by Aircraft Storage LLC, without agreement or compensation;
  •  Tradewinds was operated as a mere assetless shell, and the proceeds of the sale of its only significant asset, the airplane, were diverted from the entity to Freeman’s personal account.”

2nd Factor:  Defeat of a Rightful Claim

The Court stated:

“The second prong of the veil-piercing test is whether justice requires recognizing the substance of the relationship between the corporation and the person or entity sought to be held liable over the form because the corporate fiction was ‘used to perpetrate a fraud or defeat a rightful claim.”

The Court went on to make the unfortunate statement that there is no Colorado case that ruled “that a party seeking to pierce the corporate veil must show wrongful intent.”  The Court found:

“We conclude that defeating a potential creditor’s claim is sufficient to support the second prong. We further conclude, as a matter of first impression, that wrongful intent or bad faith need not be shown to pierce the LLC veil.”

The Court’s ruling effectively throws out the second prong of the three prong alter ego test and ignores 100+ years of corporate law.  If a company has assets sufficient to pay its debt, the creditor does not need to sue the owner and try to pierce the corporate/company veil.  It is only when the company cannot pay its debt that a creditor will sue the owner in an attempt to collect the company’s debt from the owner.

The corporate and LLC law of most if not all states provides that a fundamental asset protection concept is that the owners of the entity are not liable for the entity’s debts or obligations.  It may be appropriate in some cases to find that a rightful claim of a creditor should be paid by an owner of the company after a court finding that the company was the owner’s alter ego and used to perpetrate a fraud, but the mere fact that the creditor was not paid should never be considered and used to find the owner liable.  If people will be held liable for the debts of a company simply because the company has unpaid debts it will have a chilling affect on business and prevent many people from investing in businesses that would hire employees.

3rd Factor: Equitable Result

The Court did not discuss the facts that support a finding that an equitable result would be achieved by disregarding the corporate form, nor did it rule on the issue.  Apparently Colorado now has a two prong test to determine if the when a Colorado court will pierce the company veil and hold the owner of an LLC liable for its debts.

Let’s hope this case is appealed because it is bad law for the owners of LLCs, corporations, limited partnerships, limited liability partnerships and limited liability limited partnerships.

What Martin v. Freeman Means for LLC Members

Some commentators have written that this case is another reason people should shy away from the single member limited liability company.  I disagree.  The court did not discuss that the fact the LLC had only one member was significant.  What was significant to the court was the historical facts as to how the LLC operated and conducted its affairs.  The case stands for the proposition that LLC owners, both single and multiple members) must follow the formalities of operating the company or risk having the veil pierced and the owners becoming liable for the LLC’s debts.

Consider the facts that the Court found that cased it to conclude that the company was Freeman’s alter ego:

1.  Tradewinds’ assets were commingled with Freeman’s personal assets and the assets of one of his other entities, Aircraft Storage LLC:  This is a fundamental no no.  Never allow assets of a member to be commingled with the company’s assets.

 2.  Tradewinds maintained negligible corporate records:  Again this is a no brainer.

Your LLC must maintain a good set of financial books.  Use Quickbooks.  Have an experienced Quickbooks expert set it up.  It’s not too expensive.  Make sure all income and expenses are entered and properly annotated.

If you loan money to your LLC, the books must show the date and amount of the loan and the loan should be documented by a promissory note signed by the LLC and a resolution signed by all of the members that authorizes the loan.

If you transfer assets to the company, prepare a Bill of Sale signed by the transferor that lists the assets transferred as of the stated date.  If you are an employee of the company, sign an employment agreement with the company and have the members sign a resolution authorizing the LLC to enter into the employment agreement.

If the company enters into a contract with a third party have the members sign a resolution authorizing the LLC to enter into the contract.

 3.  The records concerning Tradewinds’ substantive transactions were inadequate:  The tasks listed in the prior paragraph apply here too.  In addition, one of the best things every LLC should do is routinely document all significant major actions taken by the company with minutes or resolutions signed by the members.  Here is a partial list of company actions that EVERY LLC should document with minutes or resolutions:

Contributions of money or property by a member to the LLC.

Loans of money by a member to the LLC.

Adding or removing a member.

Changing the percentage ownership of a member.

Employing a member or key employee.

Hiring an independent contractor.

Buying, selling or leasing real property or personal property with significant value.

Entering into contracts with third parties.

Purchasing insurance.

Applying for licenses such as a real estate broker’s license or a contractor’s license.

Doing business in another state.

Entering into an Operating Agreement with the members.

Entering into a Buy Sell Agreement with the members.

An annual meeting of members and managers (if manager managed).

It is imperative that the members of the company document all significant actions taken by the company with minutes or resolutions.  I know from being a business lawyer since 1980 that very few companies have the self discipline to document their actions.  Routinely documenting transactions is one of the most important things the members of an LLC should do to prevent a court from finding that the company was the alter ego of the members.

3.  Solution to the Lack of Records Problem: Prepare minutes and resolutions and have them signed by the members and managers.

 4.  The fact that a single individual served as the entity’s sole member and manager facilitated misuse:  Note the Court said that having a single member “facilitated” misuse.  It did not say that having a single member LLC is always a negative factor.  The Court recognized that doting the eyes and crossing the tees is less likely to occur with a single member LLC because it takes more self discipline to have meetings with yourself and document those meetings.  This fact of life is another reason why it is particularly important for single member LLCs to follow all of the formalities of operating the LLC and using a minutes service like Just a Minute.

 5.  The entity was thinly capitalized:  The law requires that every LLC to be adequately capitalized, but it does not give LLC owners a clue as to what that term means.  Adequate capitalization for an LLC means the company must always have sufficient assets for its needs, but the law doesn’t tell LLC owners exactly what constitutes adequate capitalization.  LLC owners only know if their company is adequately capitalized years later if they are sued and a judge or jury rules one way or the other on the issue.  Another problem is that adequate capitalization is a moving target because the number changes as the LLCs business facts and circumstances change.  If the LLC does not have sufficient assets to meet its capital needs then it is not adequately capitalized.  However, if the LLC does have sufficient assets to meet its capital needs a court could still find the company was not adequately capitalized.  Remedy:  Make sure the company has sufficient capital to pay its expenses plus a reserve of as much as you can afford and hope that if your LLC is ever challenged the judge or the jury will rule in your favor.

6.  Undocumented infusions of cash were required to pay all of Tradewinds’ operating expenses, including its litigation expenses:  This is a common problem that is easily avoided.  If your LLC needs money there are two ways to get the money: (a) one or more members make a capital contribution to the company, or (b) the company borrows money from one or more members or a third party lender.

Capital  Contributions:  A capital contribution is a gift of money or property by a member of an LLC to the company.  The company is not obligated to repay the contribution at any time except on liquidation if the contribution was not previously repaid.  The company should document all capital contributions by: (a) making a proper entry in the company’s books that the member made a contribution of $x on a specified date, and (b) having the members sign minutes or a resolution that authorizes and approves the contribution.

 Loans:  Regardless of who loans money to the LLC, the loan must always properly documented by: (a) having the LLC sign a promissory note that states the loan amount, interest rate and repayment terms, and (b) having the members sign minutes or a resolution that authorizes and approves the loan.  For more on this topic see my article called “How Do I Loan Money to My LLC?

Undocumented infusions of cash are a routine event in most LLCs, but that does not make it right.  Protect yourself by always documenting cash infusions.  It’s easy to do and could make the difference between whether a court will one day allow or refuse to allow a creditor of the company to get a judgment against you.  Undocumented cash infusions should never happen if you use a minutes service like Just a Minute, LLC, to automate the preparation of minutes on a monthly basis.

7.  Tradewinds was never operated as an active business:  Tradewinds only purpose was to own and operate Freeman’s airplane.  It did not have any customers or generate any revenue.  This factor is what other courts call the business purpose doctrine.  A concept in asset protection law is that a court may disregard the formation of an entity like an LLC or a corporation if it has  no business purpose.  For example there is no business purpose to transfer title to your home to your solely owned LLC while you continue to live in the home.  If the only reason you put property into an LLC is to protect it from the claims of your creditors, then the plan probably will not work.  Imagine what would happen if you take the witness stand and the plaintiff’s attorney asks why did you put your home in the LLC and you answer to prevent my creditors from getting it.  You lose.  Because Tradewinds did not have a business, customers or revenue, it failed the business purpose test.

 8.  Legal formalities were disregarded:  Yes the are legal formalities that apply to operating LLCs and your LLC must comply with all of them.  One of the reasons I wrote my 170 page book called the Arizona LLC Operations Manual is so I could notify my LLC clients and purchasers of the book about the legal formalities applicable to Arizona LLCs.  Every LLC must comply with the legal formalities of its formation state.

9.  Freeman paid Tradewinds’ debts without characterizing the transactions:  This is a no brainer.  Members should never pay the LLCs debt.  The LLC should never pay a member’s debt.  DO NOT DO THIS.  If your LLC needs money, write a check payable to the LLC and deposit the funds in the LLC’s bank account then pay the debt with the LLC’s money.  Don’t forget to properly document the transaction as a capital contribution or a loan.  If you need LLC money to pay your debt, have the LLC write a check to you so you can deposit the funds in your account and pay from your account.  Don’t forget to properly document the distribution of money as a loan, compensation or a return of capital (if you have a positive capital account balance).  Document the distribution with a promissory note (if a loan) and minutes or resolutions signed by the members.

 10.  Tradewinds’ assets, including the airplane, were used for non­entity purposes in that the plane was used by Aircraft Storage LLC, without agreement or compensation:  The LLC allowed another entity to use its $300,000 airplane without paying any compensation and without a written agreement.  Why?  This type of transaction is a red flag asking for trouble in more ways than one.  No person or entity should ever use LLC assets for non-LLC purposes unless the LLC enters into a written agreement with the user and the user compensates the LLC for the reasonable value of the use.

 11.  Tradewinds was operated as a mere assetless shell, and the proceeds of the sale of its only significant asset, the airplane, were diverted from the entity to Freeman’s personal account:  The Court is wrong on this factor.  The LLC was not assetless.  It owned a $300,000 asset free and clear.  It sold its assets and distributed the proceeds to its only member.  The Court calls this “diversion” of assets, but this is the common and accepted method of liquidating an LLC or a corporation.  The law does not require companies to retain cash in the company in perpetuity after the company liquidates its assets.  It is not right that the Court found this fact to be a negative factor.

Conclusion

This case is a wake up call to all LLCs that do not dot the eyes and cross the tees.  If your LLC is not religiously following the legal formalities of your state’s LLC law and properly documenting LLC transactions, especially transactions with members, then the company is setting the groundwork for a court ruling that the company veil should be pierced and the member(s) should be liable for the debts of the company.

Does your LLC properly document all significant transactions?  If not, then I have two statements for you:

  • If your LLC has not been documenting LLC transactions with minutes and resolutions, you won’t be doing it in the future.

Here are some other articles on this important topic:

“With the stripping of the requirement to prove wrongful conduct and expansion of liability for contingent claims, the ruling diminishes the limited liability protection afforded to all corporations and LLCs operating in Colorado. Incorporation in a jurisdiction with more robust liability protections seemingly provides no remedy – the Martin Court applied Colorado LLC statutes and case law without discussion of why Colorado law should apply to Tradewinds, a Delaware LLC. The ruling also highlights the renewed importance of maintaining adequate corporate records and practices as a means of avoiding ensnarement under the first prong of the veil-piercing test.”

“Update Corporate Records and Follow Required Formalities. Many closely held businesses do not keep their corporate record books up to date. In the event of a lawsuit against the company, a plaintiff’s attorney can attempt to “pierce to corporate veil”. This means the corporation will essentially be ignored and the owners (shareholders) will be personally liable for the corporate debts.  Following basic corporate formalities, including

  • Holding an annual shareholders meeting;
  • Holding regular meetings of the Board of Directors;
  • Avoiding any mixing of personal and corporate assets; and
  • Keeping corporate records up to date.

will all help to insure that the assets of the owner(s) of the business are insulated from any judgment against the business.”

For People Who Want to Form an LLC Themselves

If you think you might want to create a do-it-yourself Arizona LLC you must read Arizona LLC attorney Richard Keyt’s article called “Step by Step Guide: How to Form Arizona LLC 2019 in (6 Easy Steps).”

2019-10-26T15:25:19-07:00February 19th, 2012|Asset Protection, Lawsuits, Veil Piercing|1 Comment

Do Single Member LLCs Provide any Asset Protection?

Question:  Some people, including some lawyers, say that a single member limited liability company does not give the member/owner any asset protection.  Is that true?

Answer:  No.  People say this to me all the time.  I also see a lot of articles on the internet that make the same erroneous statement.  I even know of lawyers who spread this myth.

People who claim single member LLCs do not provide any asset protection are ignorant of both asset protection law and LLC law.  If a person or entity forms a single member Arizona LLC to operate a business or to own investment real estate and if the LLC is operated in compliance with applicable laws, the LLC gives its owner the same protection from the LLC’s debts and obligations that Arizona law gives to multi-member LLCs and single shareholder corporations.

Example 1:  Homer Simpson forms an Arizona LLC and owns it as his sole and separate property.  He is the only member.  Homer writes a check to the LLC for $50,000 that the LLC uses to buy a rental home.  The tenant’s mother slips on stairs in the home and dies.  Victim’s family sues the LLC and Homer and attempts to pierce the company veil and hold both the LLC and Homer liable for the family’s damages.  If Homer’s LLC has complied with applicable laws and if Homer did not have anything to do with causing or knowing of the problem with the stairs, Arizona law should protect Homer from any judgment rendered against the LLC that owns the home.  If you think this example is ridiculous, see Kerege v. Viscount Hotel Suite, one of the ten largest Arizona jury awards in 2010 that involved an elderly woman who fell down carpeted stairs in a hotel atrium and died.  The jury awarded the plaintiff $3,000,000.

I am not aware of any Arizona court case that has found the owner of a single member Arizona LLC liable under the fact pattern described above.  If you know of such a case, please send it to me.

I am not saying that the owner of a single member LLC cannot be liable for causing harm in connection with the LLC’s activities.  Never forget this important fact of life:

A person is always liable for harm caused by the person’s acts or omissions even if the acts or omissions arise while acting on behalf of a limited liability company.

Example 2:  Same facts as in Example 1 above except Homer installed the carpeting on the stairs and his installation made a bump on the stairs that caused the tenant’s mother to trip when her foot hit the bump.  Homer’s botched installation job caused the accident so he will be liable for the harm he caused and so will the LLC because he was acting on behalf of the LLC when he installed the carpet.

The result in Example 2 does not mean that a single member LLC does not provide any asset protection.  Homer would not have escaped liability for causing the accident if the LLC had been a multi-member LLC.  The number of members of the LLC is irrelevant in this scenario because Homer’s liability arises because of his bad act.

What is the Source of this Myth?

The reason some people mistakenly claim the single member LLC does not offer any asset protection arises from a misunderstanding of the legal implications of a famous (in LLC lawyer circles) bankruptcy case called “In re Albright,” No. 01-11367 (Colo. Bkrpt. April 4, 2003).  This case involved a woman who was the only member of an LLC that had assets.  She argued that the bankruptcy court could not give the assets of the LLC to her creditors because Colorado LLC law provided that the creditors’ remedy for claims against its sole member was a charging order.  The bankruptcy court rejected that argument and allowed the bankruptcy trustee to sell the LLC’s assets and give the proceeds to Albright’s creditors.

The court made some statements that it may not have liquidated the LLC if it had multiple members.  It said:

“To the extent a debtor intends to hinder, delay or defraud creditors through a multi-member LLC with ‘peppercorn’ co-members, bankruptcy avoidance provisions and fraudulent transfer law would provide creditors or a bankruptcy trustee with recourse.”

This off the cuff statement (called “dictum”*) are the basis on which the nonbelievers claim that single member LLCs do not provide any asset protection.

*Latin for “remark,” a comment by a judge in a decision or ruling which is not required to reach the decision, but may state a related legal principle as the judge understands it. While it may be cited in legal argument, it does not have the full force of a precedent (previous court decisions or interpretations) since the comment was not part of the legal basis for judgment. The standard counter argument is: “it is only dictum (or dicta).”

The Albright case did not involve a claim made against the LLC that arose from the LLC’s activities.  I call this type of claim a bottom up creditor claim.  Instead, the Albright case involved claims MADE AGAINST THE SOLE MEMBER ARISING FROM THE MEMBER’S ACTS OR OMISSIONS.  IT DID NOT INVOLVE A CLAIM THAT AROSE FROM THE ACTIVITIES OF THE LLC AND AN ATTEMPT BY THE CREDITOR TO PIERCE THE VEIL AND HOLD THE SOLE MEMBER LIABLE FOR THE DEBTS OF THE LLC.  See my graphical depiction of bottom up and top down creditors.

It takes quite a leap of ignorant faith to conclude from In re Albright that it stands for the proposition that single member LLCs lack asset protection.  Nationally known asset protection attorney Jay Adkinson says the following about single member LLCs, In re Albright and asset protection on his great website called “Asset Protection Book:”

Based on Albright, sometimes I hear planners blurt out, “Single Member LLCs provide no asset protection!” This is wrong. The lack of charging order protection is a far cry from concluding that SMLLCs are “worthless” as asset protection vehicles. SMLLCs may still provide substantial protection for owners against the liabilities of the entity itself, which are so-called “internal liabilities”.

For example: SMLLC owns a strip mall and is successfully sued by one of the tenants. If the SMLLC is adequately capitalized, is not the alter ego of the sole member, and is not used to perpetuate a fraud, the tenant may not assert liability against the member.

There is no reason that a SMLLC should be treated much differently from a sole shareholder corporation. Historically, sole shareholder corporations have contained liability within the entity and shielded the liability away from its owners.

To summarize, even if SMLLCs do not offer the same charging order protection as multiple-member LLCs, they can still be very valuable business planning vehicles. Certainly, it is preferable from a liability standpoint to own one’s business in a SMLLC than to run it as a sole proprietorship. But of course, where external liability is a concern and it is feasible to add another member, that should be done so that charging order protection arises.”

To learn more about this topic and attacks by creditors on the charging order protection offered by LLC laws in states outside Arizona, read my article called “Beware of the Single Member LLC.”

For People Who Want to Form an LLC Themselves

If you think you might want to create a do-it-yourself Arizona LLC you must read Arizona LLC attorney Richard Keyt’s article called “Step by Step Guide: How to Form Arizona LLC 2019 in (6 Easy Steps).”

Veil-Piercing

Owners of corporations and limited liability companies worst nightmare is that a creditor will sue the company and its owners and ask the court to “pierce-the-corporate-veil” and hold the owners liable for the debts and obligations of the company.  Peter B. Oh, Associate Professor of Law at the University of Pittsburgh has written a scholarly article called “Veil-Piercing.”  Here is the abstract of the article:

From its inception veil-piercing has been a scourge on corporate law. Exactly when the veil of limited liability can and will be circumvented to reach into a shareholder’s own assets has befuddled courts, litigants, and scholars alike. And the doctrine has been bedeviled by empirical evidence of a chasm between the theory and practice of veil-piercing; notably, veil-piercing claims inexplicably seem to prevail more often in Contract than Tort, a finding that flouts the engrained distinction between voluntary and involuntary creditors.

With a dataset of 2,908 cases from 1658 to 2006 this study presents the most comprehensive portrait of veil-piercing decisions yet. Unlike predecessors, this study examines Fraud, a long-suspected accessory to veil-piercing, as well as specific sub-claims in Contract, Tort, and Fraud to provide a fine-grained portrait of voluntary and involuntary creditors. And this study analyzes the rationales instrumental to a piercing decision.

The findings largely comport with our legal intuitions. The most successful civil veil-piercing claims lie in Fraud or involve specific evidence of fraud or misrepresentation. Further, claims not only prevail more often in Tort than Contract, but adhere to the voluntary-involuntary creditor distinction. Surprisingly, though, veil-piercing presents a greater risk to individual shareholders than corporate groups.