Two Common Mistakes for LLC’s (and How To Prevent Them)
10.29.2020
By: Safran Staff
WHAT DOES LIMITED LIABILITY REALLY MEAN?
A limited liability company (LLC) allows individuals to create an entity, which exists separate from its owners, for the purpose of doing business.[1] As a result of their flexibility, they have become the fastest growing type of business organization, now exceeding their traditional corporation counterparts be a 2-to-1 margin.[2]
LLCs, as implied by the name, limits the liability of it’s members to their initial investment, like a corporate shareholder.[3]
As with corporations, due to the protections afforded by an LLC, members are more willing to take calculated business risks.
“PIERCING THE CORPORATE VEIL”
Although member-managers of an LLC are shielded from liability when acting as managers, the shield is not absolute.[4] If it is necessary to prevent fraud or to achieve equity, a court may ‘pierce the corporate veil’ and hold members personally accountable.[5] For this to occur, the plaintiff must prove three elements under the “instrumentality rule:”[6]
1.“Control, not mere majority or complete stock control, but complete domination, not only of finances, but policy and business practice in respect to the transaction attacked so that the corporate entity as to this transaction had at the time no separate mind, will, or existence of its own;
2. Such control must have been used be the defendant to commit fraud or wrong;
3.The aforesaid control and breach of duty must proximately cause the injury or unjust loss complained of”.
When deciding whether the elements exist, the court will consider several factors.[7] It is imperative that the member(s) of an LLC take due care to prevent them becoming personally liable as a result of a court piercing the veil of the LLC.
With that context in mind, here are two common pitfalls of the operations of LLC’s and how they can be prevented:
1. INADEQUATE CAPITALIZATION
Members of the LLC must insure, at the inception of the LLC, the company has adequate capitalization, as courts consider this factor in determining whether to pierce the corporate veil. To prevent this from being an issue, when forming an LLC, a member must ensure that the funds of the corporation are sufficient to cover the debts owed by the corporation.[8]
To prevent a piercing of the veil, members of the LLC need to ensure that the company has sufficient capital to reasonably cover any debts that the company may take on. Furthermore, after initial debts are incurred, members should not withdraw the initial investment in the company.
2. NON COMPLIANCE WITH CORPORATE FORMALITIES
Another factor the court considers in deciding whether to pierce the veil is the company’s non-compliance with corporate formalities.[10] Corporate formalities can vary widely from one state to the next; however, there are some basic formalities that an LLC should take.
An LLC should hold regularly scheduled Member Meetings, keep accurate financial records, and follow company bylaws for compliance purposes.[11]
In addition, it is highly recommended that Officers and Directors exercise fiduciary duties by not using any corporate assets for personal gains and classifying corporate matters as confidential. It is also recommended, in avoidance of errors and liabilities, to address company contract procedures in the negotiation and signing of any business contracts. For example, allowing only Officers or Directors to authorize as well as making any company purchases in the corporation’s name.
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