Asset Protection Planning Articles – Limited Liability Companies2021-03-13T06:33:09-07:00

Asset Protection Planning Articles
Limited Liability Companies

Back to Asset Protection Planning Articles
LLC Overview2020-02-10T17:42:11-07:00

What Is an LLC?

Limited liability companies combine the best parts of partnerships and corporations.

A limited liability company (LLC) offers protection from personal liability for business debts, just like a corporation. While setting up an LLC is more difficult than creating a partnership or sole proprietorship, running one is significantly easier than running a corporation.

Separate Entity

A limited liability company is a business entity that is separate from its owners, like a corporation. However, unlike a corporation, which generally must pay its own taxes, an LLC is a “pass-through” tax entity: The profits and losses of the business pass through to its owners, who report them on their personal tax returns just as they would if they owned a partnership or sole proprietorship. Some people mistakenly think LLC stands for “limited liability corporation,” but it is not a corporation. Forming and running an LLC is less complex and requires less paperwork than a corporation.

Here are the main features of an LLC:

Limited Personal Liability

Like shareholders of a corporation, all LLC owners are protected from personal liability for business debts and claims. This means that if the business itself can’t pay a creditor—such as a supplier, a lender, injured party, disgruntled employee or a landlord— GENERALLY, the creditor cannot legally come after an LLC member’s personal assets such as their home, bank accounts, investment real properties, brokerage accounts, car, or other personal possessions. Because only LLC assets are used to pay off business debts, LLC owners stand to lose only the money that they’ve invested in the LLC.

This feature is often called “limited liability.”

Exceptions to Limited Liability

But, there are exceptions to the above rule.

While LLC owners enjoy limited personal liability for many of their business transactions, this protection is not absolute. This drawback is not unique to LLCs, however—the same exceptions apply to corporations. An LLC owner can be held personally liable if he or she:

  • personally and directly injures someone
  • personally guarantees a bank loan or a business debt on which the LLC defaults
  • fails to deposit taxes withheld from employees’ wages
  • intentionally does something fraudulent, illegal, or reckless that causes harm to the company or to someone else, or
  • treats the LLC as an extension of his or her personal affairs, rather than as a separate legal entity.

This last exception is the most important. If owners don’t treat the LLC as a separate business, a court might decide that the LLC doesn’t really exist and find that its owners are really doing business as individuals who are personally liable for their acts. To keep this from happening, make sure you and your co-owners:

  • Act fairly and legally. Do not conceal or misrepresent material facts or the state of your finances to vendors, creditors, or other outsiders.
  • Fund your LLC adequately. Invest enough cash in the business so that your LLC can meet foreseeable expenses and liabilities.
  • Keep LLC and personal business separate. Get a federal employer identification number, open up a business-only checking account, and keep your personal finances out of your LLC accounting books.
  • Create an operating agreement. Having a formal written operating agreement lends credibility to your LLC’s separate existence.

Additional Protection: Business Insurance

A good liability insurance policy can shield your personal assets when limited liability protection does not. For instance, if you are a health care professional and you accidentally injure a patient, your professional insurance liability should cover you. Insurance can also protect your personal assets in the event that your limited liability status is ignored by a court. Review all of your liability policies to make sure you know what you are covered for. Have us review those policies for you. Finally, consider the purchase of a umbrella policy.

In addition to protecting your personal assets in such situations, insurance can protect the LLC’s assets from lawsuits and claims. If it is an LLC policy, make sure you are named as an additional insured.

But your LLC won’t be protected if it doesn’t pay its bills: Commercial insurance usually does not protect personal or company assets from unpaid business debts. Insurance only covers physical injury or property damage the LLC causes.

LLC Taxes

Unlike a corporation, an LLC is not considered a separate entity  from its owners for tax purposes. Instead, it is what the Internal Revenue Code calls a “pass-through entity,” like a partnership or sole proprietorship. This means that business income passes through the business to the LLC members, who report their share of profits—or losses—on their individual income tax returns.

While an LLC itself doesn’t pay income taxes, co-owned LLCs must file Form 1065, an informational return, with the IRS each year. This form, which partnerships also have to file, sets out each LLC member’s share of the LLC’s profits (or losses), which the IRS reviews to make sure LLC members are correctly reporting their income.

For more information on LLC taxes, including the 20% pass-through deduction available to eligible LLC owners, as well as the California LLC Gross Receipts tax, see article on the YAHNIAN TAX article “How LLCs Are Taxed”.

LLC Management

The owners of most small LLCs participate equally in the management of their business. This arrangement is called “member management.”

There is an alternative management structure—called “manager management”—in which you designate one or more owners (or even an outsider) to take responsibility for managing the LLC. The nonmanaging owners (sometimes family members who have invested in the company) simply sit back and share in LLC profits.

In a manager-managed LLC, only the named managers get to vote on management decisions and act as agents of the LLC. Choosing manager management sometimes makes sense, but it might require you to deal with state and federal laws regulating the sale of securities. Alternatively, a manager managed LLC can provide in its Operating Agreement for the creation of offices such as President, VP, Secretary, etc. By that means, non manager family members can hold an office and have some authority delegated to them by the Manager.

Forming an LLC

To create an LLC, you file “articles of organization” (in some states called a “certificate of organization” or “certificate of formation”) with the LLC division of your state government. This office is often in the same department as the corporations division, which is usually part of the secretary of state’s office.

You can form an LLC with just one person.

California provides a form LLC-1 for the articles of organization, on which you need only specify a few basic details about your LLC, such as its name and address, and contact information for a person involved with the LLC (usually called a “registered agent”) who will receive legal papers on its behalf.

In addition to filing articles of organization, you must create a written LLC operating agreement. You don’t have to file your operating agreement with the state, but that doesn’t mean you can get by without one. The operating agreement is a crucial document because it sets out the LLC members’ rights and responsibilities, their percentage interests in the business, and their share of the profits. It’s best to have an YAHNIAN LAW CORPORATION design, prepare and implement your LLC Operating Agreement.

Ending an LLC

Under the laws of many states, unless your operating agreement says otherwise, when one member wants to leave the LLC, the company dissolves. In that case, the LLC members must fulfill any remaining business obligations, pay off all debts, divide any assets and profits among themselves, and then decide whether they want to start a new LLC to continue the business with the remaining members.

Your LLC operating agreement can prevent this kind of abrupt ending to your business by including “buy-sell,” or buyout, provisions that set up guidelines for what will happen when one member retires, dies, becomes disabled, or leaves the LLC to pursue other interests.

LLC Asset Protection Uses2020-02-10T17:42:34-07:00

LLCs offer two different types of protection from creditors:

  • Inside; and
  • Outside

Inside protection means that generally creditors of the entity, cannot get the personal assets of the entity’s owners for debts of the entity.

Outside protection generally means that creditors of an LLC owner cannot get the LLC interest of a owner, nor the assets of the LLC.

However, there are exceptions to the rules.

More broadly, a limited liability company among family members has several tax and asset-protection uses.

More specifically, the asset-protection aspects involve the following:

  • Providing a shield of protection to LLC owners from LLC creditors;
  • Shifting income to and among family members and away from LLC members with personal debt.
  • Sharing assets with family members (i.e., if the debtor does not own the asset, the creditors cannot reach it).
  • Valuation discounts (e.g., for minority interests, lack of marketability) relative to LLC  interests (i.e., the value of a properly structured LLC interest is generally much lower than the proportionate value of the underlying partnership assets) making the LLC interest less attractive to a member’s personal creditors.
  • The charging order limitations that shareholders of a corporation do not have.
Charging Orders2020-02-10T17:43:02-07:00

Charging Order

Corporate Stock is easily levied and sold by a shareholder creditor. By contrast, special highly protective rules applicable to collection against an interest in a partnership or LLC make these business entities effective asset-protection devices. LLC Members and Partners have no right in specific partnership property. Corp C §§15907.01, 16203, 16501. See, e.g., Nickless v Aronson (In re Katz) (Bankr D Mass 2006) 341 BR 123, 132 (bankruptcy trustee’s strong-arm powers do not give it the right to sell partnership assets; trustee is limited to partner’s state law remedy, which in turn is limited to sale of partnership interest owned by debtor).

A “charging order” is the exclusive remedy available to a creditor of a LLC member or partnership partner, superseding all other methods of attachment and execution against LLC or partnership property. CCP §§699.720, 708.310–708.320; Corp C §15907.03 (limited partnership), §16504(e) (general partnership); Evans v Galardi (1976) 16 C3d 300 (no exception if partnership is owned entirely by judgment debtors). (However, there are a few situations in which the creditor may execute directly on LLC or partnership assets, e.g., when LLC or partnership assets have been transferred in fraud of creditors,)

A charging order directs that distributions made with respect to the debtor-partner’s interest are made to the creditor instead of the debtor-partner. See Corp C §§15907.02–15907.03 (judgment creditor has rights of an assignee), §16504(a).

Charging orders are designed to allow creditors to satisfy their judgment out of partnership profits or liquidating distributions while minimizing the disruption of the partnership operation—a disruption that could destroy its going-concern value and impair the security interests held by creditors of the partnership itself. AgriTech Servs., Inc. v Groff (In re Groff) (10th Cir 1990) 898 F2d 1475; Crocker Nat’l Bank v Perroton (1989) 208 CA3d 1. If the LLC Operating Agreement or  limited partnership agreement contains a provision that restricts the sale of an interest, it also appears that the interest cannot be sold under a charging order. See Corp C §15907.02(f).

A charging order applies only to a partner’s interest in the partnership. It does not take priority over the partnership’s creditors. See CCP §699.720. Once a charging order has been issued, the debtor-partner remains a partner, but is no longer entitled to receive profits, surplus, and the proceeds of liquidating distributions until the charging order is satisfied. See Corp C §15907.02(b). There appears to be no limitation on other payments to partners in capacities other than as partner, such as for wages or consulting fees.

The remedies imposed under a charging order are progressively more drastic. The applicability of these remedies to creditors with respect to LLC or limited partnership interests is unclear, however, because Corp C §15907.02 does not include a list of remedies. The remedial structure reflects a balancing of the equities of the partners and the creditor whose claim remains unsatisfied. The initial level, the diversion to the creditor of all distributions with respect to the partnership interest charged, is similar to a garnishment. Corp C §§15907.03(a), 16504(a). The next level of remedy allows a court to appoint a receiver to facilitate collection of the judgment. Evans v Galardi (1979) 93 CA3d 291, 295 (cost of receivership is borne by defendant). The receiver’s role is limited, however, to receiving monies due with respect to the partnership interest charged, conserving partnership property, and preventing fraudulent transfer of partnership property. Mitchell v Superior Court (1972) 28 CA3d 759.

If the foregoing remedies are ineffective, the court ultimately has the power to sell the debtor’s interest in a LLC or partnership. Corp C §§15907.03(b), 16504(b); Crocker Nat’l Bank v Perroton (1989) 208 CA3d 1. If a sale of the interest is authorized, a purchaser’s rights are limited. He or she cannot compel liquidation of the partnership, has no voice in the management of the partnership, cannot control partnership investment or require partnership distributions. Estate of Bruno Bischoff (1977) 69 TC 32, 49.

The procedural safeguards and concern for nondebtor LLC members or  partners usually result in a time-consuming process of obtaining judicial approval for each step. The prospect of facing these hurdles, the outcome of which is by no means certain, may induce creditors to settle. See In re Skyline Condominiums (Bankr SD Tex 1986) 64 BR 778 (creditors took nearly 5 years to obtain charging order, finally granted in bankruptcy proceeding).

Banruptcy2020-02-10T17:43:24-07:00

Bankruptcy Aspects

The bankruptcy trustee cannot sell LLC or partnership property. Martin Mach. Co. v Williams (In re Newman) (8th Cir 1989) 875 F2d 668 (debtor and trustee in bankruptcy were entitled only to distributive share of profits and liquidating distributions). Furthermore, a bankruptcy trustee generally cannot exercise a LLC or general partner’s powers. A LLC operating agreement or limited partnership agreement usually is an executory contract that cannot be assumed without the consent of all of the limited partners. 11 USC §365(c)(1)(A)–(B); Crocker Nat’l Bank v Perroton (1989) 208 CA3d 1. Although a LLC or partnership interest can be sold by the bankruptcy trustee (11 USC §§363(b)(1), 363(l)), a LLC or partnership ordinarily is not required to liquidate if the LLC operating agreement or partnership agreement provides for a successor general partner. Sale of a LLC membership interest or general partnership interest can be prevented when the foreclosure would unduly interfere with the LLC or partnership business. Helman v Anderson (1991) 233 CA3d 840 (court considered whether debtor-partner possesses essential managerial skills and would no longer participate in business if interest sold).

Rights of Secured and Judgment Creditors against LLC Interests2020-02-10T17:44:02-07:00

Rights of Secured and Judgment Creditors

Secured creditors. A security interest in or other encumbrance against a member’s interest without any related amendment of the operating agreement does not provide the secured creditor with the ability to exercise any rights or powers of a member or to receive distributions. Corp C §17705.02(b). The secured creditor obtains rights only with respect to the transferable interest of the member. In SP Inv. Fund I LLC v Cattell (2017) 18 CA5th 898, the court held that a limited partner could contract to transfer the right to receive distributions with respect to his limited partnership interest even though the transferee had not been approved as a new limited partner.

Judgment creditors; charging orders. A lien by a judgment creditor against a member’s interest is created by service of a notice of motion for a charging order on the member and all other members of the LLC and continues unless the order is denied. CCP §708.320. A judgment creditor of a member may charge the “assignable” membership interest of a member without becoming a member. Corp C §17705.03. The purpose of the right established by a charging order is to permit the creditor to “realize on his judgment” by “appropriate supplementary proceedings or orders” against the debtor’s membership interest. See Taylor v S & M Lamp Co. (1961) 190 CA2d 700, 711.

Receivers. A court may appoint a receiver for the share of a member’s distributions from the LLC that are “subject to the charging order” and may “make all other orders necessary to give effect to the charging order.” Corp C §17705.03(b). In addition, under CCP §187, a court can apply other “practical means for enforcing” the right of the creditor. In Phillips v Fotouhi (2011) 197 CA4th 1132, 1143, a judgment debtor was found liable for breaching the partnership agreement when he started a new partnership and took clients with him. Shortly thereafter, the new partnership began doing business as a corporation, which took over the partnership’s office lease and continued to operate in the same location. In granting the charging order, the superior court applied principles of successor liability and found that the corporation was a continuation of the partnership.

Foreclosure. To obtain the remaining benefits of the transferable interest, the creditor must establish a right to foreclose on the membership interest. The court may order a foreclosure on the membership interest at any time if the court determines that foreclosure is appropriate in light of the relevant equities. See Hellman v Anderson (1991) 233 CA3d 840, 853. The purchaser at the foreclosure sale will obtain the rights of a “transferee.” Corp C §17705.03(b)(3). The judgment debtor and the other members of the LLC retain the right to redeem the membership interest at any time before foreclosure. Corp C §17705.03(c).

Other remedies, including fraudulent conveyance. The charging order provisions of Corp C §17705.03 are stated to be the exclusive remedy for a judgment creditor to satisfy a judgment out of a membership or transferable interest in an LLC. Corp C §17705.03(f). However, given the associated rights of a creditor under the California Code of Civil Procedure to seek foreclosure, a receiver, or other practical means for enforcing the creditor’s rights, along with the potential to “reverse veil pierce” the liability limitations and impose liability on the LLC for a member’s obligations, the charging order provisions in RULLCA may not be exclusive in practice. A California creditor also may seek to avoid the charging order limitations by asserting a fraudulent conveyance or claiming a breach of the fiduciary duty obligations of the members to each other. Tiering of LLCs may be helpful in providing additional protection for the LLC and other members against a member’s creditors.

Reverse veil piercing. For a case allowing potential alter ego liability with respect to an LLC for the obligations of a member (“reverse veil piercing”), see Curci Invs., LLC v Baldwin (2017) 14 CA5th 214. In contrast, reverse veil piercing was not allowed in Phillips, Spallas & Angstadt, LLP v Fotouhi (2011) 197 CA4th 1132 or Postal Instant Press, Inc. v Kaswa Corp. (2008) 162 CA4th 1510, but neither Phillips nor Postal Instant Press involved LLCs.

LLCs-Detailed Discussion of Liability Protection Aspects2020-02-10T17:44:28-07:00

LLCs and Limited Liability Protection

As the name implies, limited liability companies (“LLCs”) are limited liability entities that protect their owners (also called members), managers, and the LLC itself from certain types of legal liability. But just what is this limited liability, and how limited is it really?
What Type of Liability Protection Do You Get With an LLC?

The main reason people form LLCs is to avoid personal liability for the debts of a business they own or are involved in. By forming an LLC, only the LLC is liable for the debts and liabilities incurred by the business—not the owners or managers. However, the limited liability provided by an LLC is not perfect and, in some cases, depends on what state your LLC is in.

Before you get started on your business venture, you’ll want to consider the potential liability risks of your business and the protection you’ll get from an LLC. Specifically, you should think about the following liability risks you take on as an LLC owner:

1) personal liability for your LLC’s debts

2) personal liability for actions by LLC co-owners or employees related to the business

3) personal liability for your own actions related to the business, and

4) the LLC’s liability for other members’ personal debts.
Personal Liability for Your LLC’s Debts

In all states, if you form an LLC to operate your business, and don’t personally guarantee or promise to pay its debts, you will ordinarily not be personally liable for the LLC’s debts. Thus, your LLC’s creditors can go after your LLC’s bank accounts and other property, but they can’t touch your personal property, such as your personal bank accounts, home, or car. Many creditors, however, don’t want to be left holding the bag if your business goes under so they will demand that you personally guarantee any business loans, credit cards, or other extensions of credit to your LLC. In that situation, you would be personally liable if your LLC’s assets fall short.
Personal Liability for Actions by LLC Co-Owners and Employees

In all states, having an LLC will protect owners from personal liability for any wrongdoing committed by the co-owners or employees of an LLC during the course of business. If the LLC is found liable for the negligence or wrongdoing of its owner or employee, the LLC’s money or property can be taken by creditors to satisfy a judgment against the LLC. But the LLC owners would not be personally liable for that debt. The owner or employee who committed the act might also be personally liable for his or her actions but a co-owner of the LLC who was not involved in the act or wrongdoing would not be.

Example: While making a bread delivery to a local supermarket, Lloyd, an employee of the Acme Bakery, LLC, runs over and kills a brain surgeon in a crosswalk. It turns out Lloyd was driving while drunk. Acme Bakery is sued and found liable for its employee’s negligent actions while on the job. All of Acme’s business property, assets, money, and insurance can be used to pay the judgment awarded to the surgeon’s heirs. Acme LLC’s owners, however, are not personally liable for the LLC’s employee’s actions so their personal assets cannot be taken to pay any judgment against Acme.
Personal Liability for Your Own Actions

There is one extremely significant exception to the limited liability provided by LLCs. This exception exists in all states. If you form an LLC, you will remain personally liable for any wrongdoing you commit during the course of your LLC business. For example, LLC owners can be held personally liable if they:

personally and directly injure someone during the course of business due to their negligence
fail to deposit taxes withheld from employees’ wages
intentionally do something fraudulent, illegal, or reckless during the course of business that causes harm to the company or to someone else, or
treat the LLC as an extension of their personal affairs, rather than as a separate legal entity.

Thus, forming an LLC will not protect you against personal liability for your own negligence, malpractice, or other personal wrongdoing that you commit related to your business. If both you and your LLC are found liable for an act you commit, then the LLC’s assets and your personal assets could be taken by creditors to satisfy the judgment. This is why LLCs and their owners should always have liability insurance.

Example: Assume that two of the three owners of Acme Bakery LLC (from the example above), knew that their driver was drunk, but let him make deliveries anyway. They can be sued and held personally liable for negligence by the brain surgeon’s heirs.
Your LLC’s Liability for Members’ Personal Debts

An LLC’s money or property cannot be taken by creditors of an LLC’s owner to satisfy personal debts against the owner. However, instead of taking property directly, there are other things that creditors of an LLC owner can do to try to collect from someone with an ownership interest in an LLC. What is allowed varies state by state and includes, in order of severity, the following:

getting a court to order that the LLC pay to the creditor all the money due to the LLC owner/debtor from the LLC (this is called a “charging order”)
foreclosing on the owner/debtor’s LLC ownership interest, or
getting a court to order the LLC to be dissolved.

None of these actions are good but some are much worse than others. If an LLC interest is foreclosed upon, the foreclosing creditor becomes the permanent owner of all the debtor-member’s financial rights, including the right to receive money from the LLC. If a court orders an LLC dissolved, it will have to cease doing business and sell all of its assets.

State LLC laws vary widely on how many of these steps creditors are allowed to take. All states allow creditors to obtain a charging order against an LLC owner’s interest. Many states limit creditors remedies to this first step (obtaining a charging order). Other states allow creditors to foreclose on the owner’s LLC interest or even can order the LLC dissolved to pay off an owner’s debt. For more on charging orders and what personal creditors’ of LLC owners can–and can’t–do, including the state law variations, see LLC Asset Protection and Charging Orders: An Overview of State Laws.
Single Member LLCs and Asset Protection

In some states, it’s not clear whether single member LLCs will receive the same liability protection from personal creditors of the LLC owner as multi-member LLCs. The rationale for limiting an LLC member’s personal creditor’s remedies to a charging order is to protect other LLC members from having to share management of their LLC with an outside creditor. There are no other LLC members to protect in a single member LLC so the rationale for limiting creditors’ remedies to a charging order doesn’t apply. For this reason, courts in some states have found that single member LLCs are not entitled to the charging order protection and creditors are entitled to pursue other remedies against the LLC member, including foreclosing on the member’s interest or ordering the LLC dissolved to pay off the debt.

A limited liability company (LLC) has been described as a “hybrid” between a partnership and a corporation. It enjoys the “pass-through” tax treatment of a partnership with the limited liability accorded corporate shareholders. [See Corps.C. § 17701.01 et seq.; Ontiveros v. Constable (2018) 27 CA5th 259, 273, 237 CR3d 892, 901-902; Western Surety Co. v. La Cumbre Office Partners, LLC (2017) 8 CA5th 125, 131, 213 CR3d 460, 464; People v. Pacific Landmark (2005) 129 CA4th 1203, 1211-1212, 29 CR3d 193, 198; see also Robinson v. Glynn (4th Cir. 2003) 349 F3d 166, 168 (“LLCs are noncorporate business entities that offer their members limited liability, tax benefits, and organizational flexibility”)]

Members’ Limited Liability: Ordinarily, only the LLC can be held responsible for the entity’s debts. Subject to narrow exceptions, the LLC members are not personally liable for the LLC’s obligations and/or liabilities and thus enjoy the same “limited liability” as corporate shareholders. [Corps.C. § 17703.04

5. [6:9] Centralized Management Optional: All of the members may partake in management of the LLC (akin to a general partnership) or may, in the LLC’s articles of organization, provide for centralized management (akin to a limited partnership or, in certain respects, a corporation). See discussion at ¶ 6:450 ff.
a. [6:10] Caution—securities law considerations: Members who do not participate in LLC management may be deemed passive investors, and the membership interests may be deemed securities. See ¶ 7:81 ff.
6. [6:11] Flexibility: The LLC form provides far greater flexibility than a corporation or a limited partnership. For a comparison of the LLC form with the corporate and limited partnership forms of doing business, see Ch. 2.
7. [6:12] Separate Legal Entity: Like partnerships and corporations, an LLC is recognized as a legal entity separate and apart from its members. It has all the powers of a natural person in carrying out its activities, including to sue and be sued, make contracts, borrow and lend money, acquire and sell property, invest, make donations, etc. [See Corps.C. §§ 17701.04(a), 17701.05; PacLink Communications Int’l, Inc. v. Sup.Ct. (Yeung) (2001) 90 CA4th 958, 963, 109 CR2d 436, 439; Abrahim & Sons Enterprises v. Equilon Enterprises, LLC (9th Cir. 2002) 292 F3d 958, 962 (applying Calif. law)] (Caution: The operating agreement may not vary the LLC’s capacity to sue and be sued in its own name; see ¶ 6:105.)
a. [6:13] No member claim to LLC assets: Like corporate shareholders, a member has no direct ownership interest in specific company property. Once members contribute assets to an LLC, those assets become assets of the LLC and not assets of the members. [Kwok v. Transnation Title Ins. Co. (2009) 170 CA4th 1562, 1570-1571, 89 CR3d 141, 147; Abrahim & Sons Enterprises v. Equilon Enterprises, LLC, supra, 292 F3d at 963] 8. [6:14] Perpetual Duration: An LLC has perpetual duration (unless the articles or operating agreement provide otherwise). [Corps.C. § 17701.04(c)]

MAINTAINING LIMITED LIABILITY PROTECTION

§13.2 A. Alter Ego Liability

Members remain subject to alter ego liability. The formation of an LLC generally shields its members and managers from personal liability for the acts of the entity, whether that liability arises in contract, tort, or otherwise. Corp C §17703.04(a). However, the California Revised Uniform Limited Liability Company Act (RULLCA) provides that the members remain subject to liability under the common law governing alter ego liability and subject to personal liability “under the same or similar circumstances and to the same extent as a shareholder of a corporation.” Corp C §17703.04(b). See §§6.25–6.31. See, e.g., Toho-Towa Co. v Morgan Creek Prods., Inc. (2013) 217 CA4th 1096 (alter ego finding with respect to three affiliated entities). This statutory language seeks to establish the same standard for disregarding the entity as is applicable to corporations. There is one exception: The failure of LLC members or managers to hold meetings or observe similar formalities will not be a factor establishing a member’s alter ego or personal liability if the LLC’s articles of organization or operating agreement do not expressly require that meetings of members or managers be held. Corp C §17703.04(b). See §6.31. For further discussion of the alter ego doctrine and of disregarding the corporate entity, see generally Organizing Corporations in California, chap 1A (3d ed Cal CEB). See also §§6.25–6.31.

Reverse veil piercing. For a case allowing potential alter ego liability with respect to an LLC for the obligations of a member (“reverse veil piercing”), see Curci Invs., LLC v Baldwin (2017) 14 CA5th 214. In Curci, the court noted that a creditor does not have the same options against a member of an LLC as it has against a shareholder of a corporation. “[I]f the debtor is a member of an LLC, the creditor may only obtain a charging order against distributions made to the member…. The debtor remains a member of the LLC with all the same rights to manage and control the LLC, including … the right to decide when distributions to members are made, if ever.” 14 CA5th at 223. The court therefore ruled that reverse veil piercing might be available. In contrast, reverse veil piercing was not allowed in Phillips, Spallas & Angstadt, LLP v Fotouhi (2011) 197 CA4th 1132 or Postal Instant Press, Inc. v Kaswa Corp. (2008) 162 CA4th 1510, but neither Phillips nor Postal Instant Press involved LLCs.

b. Alter Ego Doctrine

An exception to the general limitation on the personal liability of a member for the obligations of an LLC is set forth in Corp C §17703.04(b). Corporations Code §17703.04(b) provides that a member will be liable under the common law governing alter ego liability and also for any obligation or liability of the LLC (arising in contract, tort, or otherwise) in the same or similar circumstances and to the same extent as a shareholder of a corporation would be, with the following exception: If the articles of organization or operating agreement do not expressly require the LLC to hold meetings of members or managers, then the failure to hold meetings or to observe formalities relating to meetings is not to be considered a factor tending to establish that a member has personal liability for any of the LLC’s obligations or liabilities.

As discussed in §§6.26–6.31, the common law governing alter ego liability is part of the analysis in determining potential liability of shareholders. Accordingly, to determine the potential liability of a member for LLC obligations, the potential liability of shareholders for a corporation’s obligations should be analyzed. Under normal circumstances, shareholders’ liability is limited to their investment in the corporation. This protection from personal liability may be lost, however, if a court finds a basis for invoking the alter ego doctrine. Under this doctrine, a court may disregard the legal fiction of a corporation’s separate existence distinct from that of its shareholders and find shareholders personally liable for corporate debts and obligations if it would be inequitable not to do so. See generally Mesler v Bragg Mgmt. Co. (1985) 39 C3d 290, 301; Toho-Towa Co. v Morgan Creek Prods., Inc. (2013) 217 CA4th 1096 (alter ego finding with respect to three affiliated entities); Sonora Diamond Corp. v Superior Court (2000) 83 CA4th 523, 538.

NOTE: A variation of the alter ego doctrine known as reverse veil piercing (or reverse alter ego) occurs when a third party creditor of an individual shareholder is allowed to pierce the corporate veil in order to reach corporate assets. In Postal Instant Press, Inc. v Kaswa Corp. (2008) 162 CA4th 1510, 1512, the court of appeal rejected the doctrine, but in Curci Invs., LLC v Baldwin (2017) 14 CA5th 214, the court distinguished Postal Instant Press, holding that application of the doctrine to reach assets of an LLC was possible under the facts of that case.

§6.26 (1) Reason for Invoking Doctrine

The principal reason for invoking the alter ego doctrine is that failure to do so would work an injustice on the corporation’s creditors or other third parties. Misik v D’Arco (2011) 197 CA4th 1065, 1072; Zoran Corp. v Chen (2010) 185 CA4th 799, 810. Its purpose is to prevent corporate shareholders from attempting to use the corporation as a shield against liabilities that would otherwise inure to them personally. See, e.g., Minton v Cavaney (1961) 56 C2d 576 (tort claims); Minifie v Rowley (1921) 187 C 481 (contractual obligations).

§6.27 (2) Two-Pronged Test

As stated by the California Supreme Court in Mesler v Bragg Mgmt. Co. (1985) 39 C3d 290, 300 (citing Automotriz del Golfo de Cal. v Resnick (1957) 47 C2d 792, 796), there are two general requirements for application of the alter ego doctrine: “(1) that there be such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist and (2) that, if the acts are treated as those of the corporation alone, an inequitable result will follow.” Because the alter ego doctrine is equitable, its application varies according to the circumstances in each case. Misik v D’Arco (2011) 197 CA4th 1065, 1071. Although the doctrine does not depend on the presence of actual fraud, bad faith is an underlying consideration and is usually found in some form or another whenever the trial court has been justified in disregarding the corporate entity. Associated Vendors, Inc. v Oakland Meat Co. (1962) 210 CA2d 825. See §6.28.

§6.28 (3) Typical Fact Patterns

In Associated Vendors, Inc. v Oakland Meat Co. (1962) 210 CA2d 825, 838, the court analyzed a number of cases in which the corporate entity had been disregarded and produced the following list of factual circumstances, which can serve as a checklist for determining whether the alter ego doctrine might be applicable (210 CA2d at 838):

Commingling of funds and other assets, failure to segregate funds of the separate entities, and unauthorized diversion of corporate funds or assets to other than corporate uses;
Treatment by an individual of the assets of the corporation as his or her own;
Failure to obtain authority to issue stock or to subscribe to or issue the same;
Holding out by an individual that he or she is personally liable for the debts of the corporation;
Failure to maintain minutes or adequate corporate records and confusion of the records of the separate entities;
Having identical equitable ownership in the two entities, identical individuals having domination and control of the two entities, identical directors and officers of the two entities in supervision and management, or sole ownership of all of the stock in a corporation by one individual or the members of a family;
Use of the same office or business location or employment of the same employees or attorney;
Failure to adequately capitalize the corporation, or the total absence of corporate assets;
Use of a corporation as a mere shell, instrumentality, or conduit for a single venture or the business of an individual or another corporation;
Concealment and misrepresentation of the identity of the responsible ownership, management, and financial interests or concealment of personal business activities;
Disregard of legal formalities and failure to maintain arm’s length relationships among related entities;
Use of the corporate entity to procure labor, services, or merchandise for another person or entity;
Diversion of assets from a corporation by or to a stockholder or other person or entity, to the detriment of creditors, or manipulation of assets and liabilities between entities so as to concentrate the assets in one and the liabilities in another;
Contracting with another with intent to avoid performance by use of a corporate entity as a shield against personal liability or use of a corporation as a subterfuge for illegal transactions; and
Formation and use of a corporation to transfer to it the existing liability of another person or entity.
See also Toho-Towa Co. v Morgan Creek Prods., Inc. (2013) 217 CA4th 1096; Zoran Corp. v Chen (2010) 185 CA4th 799; VirtualMagic Asia, Inc. v Fil-Cartoons, Inc. (2002) 99 CA4th 228.

§6.29 (4) Source and Adequacy of Funding

Undercapitalization is commonly found in alter ego cases. See, e.g., Nilsson, Robbins, Dalgarn, Berliner, Carson & Wurst v Louisiana Hydrolec (9th Cir 1988) 854 F2d 1538, 1544 (applying California law); Minton v Cavaney (1961) 56 C2d 576. As stated by the court of appeal in Toho-Towa Co. v Morgan Creek Prods., Inc. (2013) 217 CA4th 1096, 1107:

Undercapitalization of the business, commingling of corporate and personal funds, and failure to observe the corporate formalities are examples of business practices that would leave individual shareholders vulnerable to a finding of alter ego liability.

However, if the LLC members have made an equity investment or provided other sources of funding for the company’s initial operations sufficient to permit it to operate as a viable business entity, the adequacy of funding requirement is ordinarily considered met. The initial funding of the company need not be solely through equity investments. A key test is whether the company had funds available (either as equity or as debt) for a sufficient period of time to enable it to begin its business and develop the business to the point of economic viability. See 2 Marsh, Finkle & Sonsini, Marsh’s California Corporation Law §16.22 (4th ed 2000).

§6.30 (5) Segregation of Personal and Company Affairs

Counsel should advise LLC members to keep their personal business carefully segregated from the company’s business. Personal funds or other assets of members should never be commingled with those of the company, and all dealings between members and the company should be at arm’s length and properly documented. See generally §6.28. See also Toho-Towa Co. v Morgan Creek Prods., Inc. (2013) 217 CA4th 1096 (although entities were formed as separate corporations, they were operated with integrated resources and exploited the same assets). It is particularly important that company assets not be used by the members for their personal benefit. See Riddle v Leuschner (1959) 51 C2d 574.

§6.31 (6) Observing Formalities

In the corporate alter ego context, a common trap for shareholders is neglecting corporate formalities. The sole or majority shareholder who runs the corporation “out of his back pocket,” fails to hold meetings, and does not keep adequate books and records is especially vulnerable. If such a corporation becomes unable to meet its obligations promptly, creditors may discover and use this disregard of corporate formalities as a significant reason for invoking the alter ego doctrine and obtaining a judgment against the shareholder. See Temple v Bodega Bay Fisheries, Inc. (1960) 180 CA2d 279. See also Counseling California Corporations §3.86 (3d ed Cal CEB) for a sample attorney-client letter containing a checklist for avoiding alter ego liability.

For LLCs, if the operating agreement does not require that meetings of members or managers be held, the failure to hold meetings or to observe certain formalities pertaining to the calling or conducting of meetings cannot be a reason for invoking the alter ego doctrine. Corp C §17703.04(b). See §6.25. Thus, unless members have a strong need to require that meetings be held at certain times, the drafting attorney should consider the benefit of a provision that allows for meetings to be held on an “as needed” basis. See, e.g., §§9.42, 9.55, 10.29. In any event, the company should maintain adequate books and records, not only to reduce the risk of a successful alter ego claim, but also to satisfy its statutory requirements. See Corp C §17701.13. See, e.g., §§9.48–9.52, 10.34–10.37. See also §13.16 concerning books and records.

§6.32 c. Forced Contributions

Any person with a claim against an LLC may enforce an existing obligation of a member to make a contribution to the LLC, or to return to the LLC money or other property paid or distributed to the member. Corp C §17704.03(c). See §§6.46–6.52 concerning a member’s obligation to make capital contributions. See §§6.53–6.58 concerning distributions to members. However, a creditor cannot enforce a conditional obligation of a member, such as an obligation to make a capital contribution following a discretionary call if the call has not occurred, unless the condition has been satisfied or waived. Corp C §17704.03(b).

§6.33 d. Return of Improper Distributions

Members are obligated to return distributions from an LLC if (Corp C §§17704.06(c), 17704.05(a)

The member had actual knowledge of facts indicating the impropriety of the distribution, and
After the distribution, either
The LLC would not be able to pay its debts as they become due in the ordinary course of the limited liability company’s activities; or
The LLC’s total assets would be less than the sum of its total liabilities plus the amount that would be needed, if the LLC were to be dissolved, wound up, and terminated at the time of the distribution, to satisfy the preferential rights on dissolution, winding up, and termination of members whose preferential rights are superior to those of persons receiving the distribution.
An action to enforce an obligation to return a distribution must be brought within 4 years after the distribution is made. Corp C §17704.06(e). Creditors have a right to enforce the obligations of members to return improper distributions. See §6.32.

NOTE: Even if a member is not obligated under Corp C §17704.06 to return an LLC distribution, a member may nevertheless be liable to return it under the California Civil Code provisions relating to fraudulent transfers (CC §§3439–3439.12) if the distribution left the LLC with unreasonably small capital. See CC §3439.04.

For further discussion of LLC distributions, see §§6.53–6.58.

§6.34 e. After Dissolution

Members of a dissolved LLC are subject to liability for causes of action against the dissolved company whether the cause of action arose before or after the dissolution of the company. A member’s liability is limited to the company assets distributed to the member on dissolution. However, it is not limited to the member’s prorata share of the claim. Corp C §17707.07(a)(1).

If the amount of distributed assets that a member is required to return exceeds the sum of that member’s prorata share of the claim and the amount for which the member could otherwise be held liable under the California Revised Uniform Limited Liability Company Act (RULLCA) for receiving an improper distribution, the member has the right to seek contribution for the excess from the other members or managers. See Corp C §17707.07(a)(1)(B).

Any action against a member of a dissolved LLC to return assets distributed on dissolution of the company must commence before the earlier of (Corp C §17707.07(a)(2))

The expiration of the statute of limitations applicable to the cause of action, or
Four years after the effective date of the dissolution of the LLC.

§6.35 2. Managers

No person who is a manager of an LLC will be personally liable under any court judgment or otherwise for any obligation of the LLC, whether that obligation arises in contract, tort, or otherwise, solely by reason of being a manager. Corp C §17703.04(a). This liability limitation is the same as the one provided in RULLCA for the benefit of members of an LLC. See Corp C §17703.04(a).

Corporations Code §17703.04(c) provides that nothing in Corp C §17703.04 shall be construed to affect the liability of a member to third parties for the member’s own participation in tortious conduct. RULLCA does not contain a similar provision with respect to the tort liability of managers or officers. Although this omission raises the question of whether the failure to include such a provision was intended to somehow limit the liability of managers and officers to third parties for their own tortious conduct, it seems unlikely that courts would read such a liability limitation into RULLCA. See, e.g., People v Pacific Landmark, LLC (2005) 129 CA4th 1203 (LLC’s manager was subject to personal liability for participating in criminal activity while performing his managerial duties; LLC had leased premises to an illegal business and allowed it to persist; court held that manager was not insulated from liability by virtue of prior Corp C §17158(a) for his personal involvement in aiding and abetting public nuisance and for failing to abate it, which forced city to bring red light abatement action).

As protection for a member or manager against such personal liability, the articles of organization or operating agreement may provide for indemnification as discussed in §6.42. In addition, the operating agreement may eliminate or limit a member or manager’s liability to the LLC and members for money damages, except for the following (Corp C §17701.10(g)):

Breach of the duty of loyalty,
A financial benefit received by the member or manager to which the member or manager is not entitled,
A member’s liability for excess distributions,
Intentional infliction of harm on the LLC or a member, and
An intentional violation of criminal law.

B. Other Sources of Liability

General rule: Managers and members not personally liable. In general, the formation of an LLC protects its managers and members from personal liability for debts, obligations, or other liabilities of the LLC, whether arising in contract, tort, or otherwise, solely by reason of being a member or manager (or both). Corp C §17703.04(a).

Personal liability by contract. RULLCA expressly permits the articles of organization or written operating agreement to provide that a member will be personally liable for any or all of the debts, obligations, or liabilities of the LLC, but requires that any such provision imposing personal liability specifically reference Corp C §17703.04(e). See Corp C §17703.04(e). To minimize the possibility of a manager or member being held personally liable for LLC obligations, any provision in the articles of organization or operating agreement imposing liability on a manager or member should be removed or narrowly drafted, and all separate agreements signed by a manager or member should be reviewed to make certain that a manager or member signing in a representative capacity does not unintentionally create personal liability.

Effect of certificate of cancellation. An LLC that has filed a certificate of cancellation will continue to exist for the purpose of winding up the affairs of the LLC, prosecuting and defending actions by or against it in order to collect and discharge obligations, disposing of and conveying its property, and collecting and dividing its assets. See Corp C §17707.06(a); DD Hair Lounge, LLC v State Farm Gen. Ins. Co. (2018) 20 CA5th 1238, 1243. Corporations Code §17707.08(b)(i) states that a certificate of cancellation is to be filed on completion of the winding up of affairs in accordance with Corp C §17707.06. Corporations Code §17707.08(c) states that, on filing a certificate of cancellation, an LLC is cancelled and its “powers,” rights, and privileges shall “cease.” The ambiguity among the certificate of dissolution, the certificate of cancellation, and the applicable authority of the manager is likely to be addressed in future legistation. Pending that correction, some commentators have noted a possible loss of liability protection for actions occurring after the filing of a certificate of cancellation. However, the language of Corp C §17707.06(a) expressly authorizes continued actions by the LLC. See DD Hair Lounge, LLC v State Farm Gen. Ins. Co., supra.

Other sources of liability. A member or manager of an LLC may also be personally liable for the LLC’s acts as a result of the following:

Prohibited distributions made to that member in violation of Corp C §17704.05 or §17707.05 that can be challenged by the LLC’s creditors (see §§6.33–6.34);
Distributions in violation of Corp C §17704.05 to which the member of a member-managed LLC or manager of a manager-managed LLC consented (see Corp C §17704.06(a)), unless the member is a member of a member-managed LLC in which the operating agreement expressly relieves the member of the authority and responsibility to consent to distributions and imposes that authority and responsibility in one or more other members (see §6.33);
Breach of any of the fiduciary duties of care or loyalty or the obligation of good faith and fair dealing (see §§6.36–6.40);
Participation in tortious conduct (Corp C §17703.04(c)) (see §6.24);
A written guaranty or other contractual obligation entered into by the member, other than an operating agreement (Corp C §17703.04(c)) (see §6.24);
Conspiring with another party, or aiding and abetting another party, in a breach of a fiduciary duty or tortious conduct (see, e.g., American Master Lease LLC v Idanta Partners, Ltd. (2014) 225 CA4th 1451, modified (May 27, 2014, B244689) 2014 Cal App Lexis 460); or
Failure to pay withholding taxes (see §13.11).

C. Steps to Minimize Liability

To minimize the possibility of personal liability being imposed on a member or members for acts of the LLC, counsel should observe the following precautions:

All operating formalities specified in the operating agreement or articles of organization should be respected. Although LLCs are not required to hold meetings (see §13.20), if the operating agreement provides for them, a minute book should be maintained, with properly executed minutes or written consents for all meetings of members or managers. The minutes should reflect compliance with all necessary approval requirements by the members or managers.
The LLC should be adequately capitalized to pursue the business activities in which it is engaged or proposes to engage, including anticipated liabilities. Proper records should be maintained as evidence of the adequacy of capitalization. The LLC should also obtain adequate insurance as protection against unanticipated liabilities.
All transactions between the LLC and its owners, both during its operations and while winding up the LLC (see Corp C §§17704.09–17707.06(a)), should be fully disclosed to all members and should be fair to the LLC, and informed consent should be obtained when appropriate (see §§6.36–6.40).
The status of the LLC as a separate legal entity should be respected in all its operations. The LLC’s funds should not be commingled with the funds of its members, managers, or any third party. The LLC should have its own separate bank account. In addition, separate financial books and records for the LLC should be maintained that are distinct from those of members, managers, or any other entity.
The LLC should conduct all business in its own name, not in the individual name of any manager or member. To ensure that third parties are not confused in their dealings with the LLC:
Letterhead, bills, invoices, and other business forms used by the LLC should show its full legal name (or fictitious business name), address, and telephone number(s).
The LLC’s telephone number(s) should be listed under its full legal or fictitious business name in all phone and business directories.
The LLC’s full legal or fictitious business name should appear on all LLC signs or advertisements, including signs at its principal place of business. Employee business cards should also show the LLC name.
Contracts should be entered into in the LLC’s name and executed with signature blocks that clearly identify the signing party as an agent of the LLC.
The LLC should be properly qualified to do business in each state in which registration is required.
If the operating agreement is to include a provision personally obligating any member for any debts, obligations, or liabilities of the LLC, the provision should be carefully drafted to specify and limit, if appropriate, these liabilities and to specify which member or members personally will be liable.
If the consent of a third party is required for any actions of the LLC, the operating agreement should be carefully drafted to delineate the requirements.

Go to Top