Be Careful! Structuring Your Business as an LLC Is Not a Guarantee of Liability Protection

By Stan Huser

How well does your LLC really protect you personally from claims against your company? The answer depends on how well you follow the rules. If you are sloppy in how you operate your LLC, you may find that you don’t have liability protection at all.

Many startups and small businesses structure their companies as a Limited Liability Company (LLC). Doing so gives them many of the same liability protections granted to a corporation, but with greater ease of use and less paperwork.

The LLC is a flexible structure that allows partners to collaborate in a venture, with each receiving income directly as personal income and no corporate tax to pay. It offers the traditional protections of the corporation, shielding personal assets by limiting responsibility for the debts of the company.

And yet with all its advantages, it's a big mistake to think of it as a magic cloak that will automatically protect you.

A court can cut through that magic cloak, or "pierce the veil" of that protection, if it determines that your business entity is really just your "alter ego." This is a way of saying you’re using the business in name only. And if you blur the lines between yourself and your LLC too much, the court may rule that the LLC is really just you operating as your alter ego. So be careful not to act without accountability to others in your company or to the requirements placed on your LLC as a registered business entity.

Some of the dangers

One of the most common ways you can get into trouble is through the commingling of funds. If you treat your business bank account as your personal reservoir to dip into and pay back later, if you deposit business checks into your personal account, or pay bills owed by the company through your personal checking account, you're commingling.

Mixed-use assets pose a similar danger. These are things like a vehicle, equipment, furnishings, and the like that you use both in your business and your personal life. Vehicles used both for business and personal use perhaps post the most common danger for small businesses and sole proprietors who create single-member LLCs.

If you mix assets, you must be sure to keep a very clear record of when and for which purpose you use them. If your SUV is also your company car, don’t claim it for business when you drive it to your beach house.

Blaze a paper trail

The simple solution to avoid commingling is to act as if the business entity is in fact a separate person. If you use a personal vehicle for business use, document this in a log and claim reimbursements in written form. Don't pay personal bills with company checks, use a reimbursement procedure to keep records straight. If money must transfer between personal and business accounts, do it formally through written agreements. Create a paper trail of separateness.

The operating agreement of every LLC should spell out very precisely the roles, rights, and responsibilities of each member. Even though an LLC isn’t required to hold specific meetings, it’s still wise to hold some if you have other members. Specify that you will be holding meetings in your operating agreement, and make sure to hold them. Also, always keep minutes, especially of important decisions made.

A single-member LLC can specify in the operating agreement annual meetings with its accountant, other professionals, or employees—anyone considered part of the running of the business. It’s important to keep a record of all meetings, and every single-member LLC should keep minutes of such meetings, as well as decisions made and resolutions of the company. It’s also important to show the business structure as separate from the single-member owner.

Adhere to any decision-making procedures specified to avoid showing that one person is really running the company—a little democracy eliminates that alter ego. And for any size of company, all decisions that affect the company and its finances should be recorded.

Be a stickler too with the outside world. Add your company signature to all communications and especially financial documents that relate to the business. Use stationery and collaterals that are exclusive to the company brand. Also, be aware of when you're on duty and when you're not.

Remember to file all required reports with your state, including any other states in which you're registered to do business. An entity is required to be in "good standing" with the state, which means having all its paperwork current. Falling into bad standing will show a court that you’re not taking your separate business entity seriously.

Mind the money

There are several other triggers that can cause a court to pierce the veil of your LLC protection. If you've applied for business loans on a lie or misrepresentation, or obtained credit with a landlord or vendor without any clear way to pay, a court will look for fraudulent intent.

One consideration will be whether the LLC was adequately funded at its creation to pay its necessary operating costs. Inadequate capitalization is a factor that can lead a court to decide that your LLC is really your alter ego. In particular, courts look at the amount of money put into the LLC at its formation.

If you're operating on a wing and a prayer and bootstrapping business growth, be aware that you may lose your liability protections if someone sues you. One cardinal sin is to leave a vendor holding an "unjust cost." If someone in good faith bears an expense because you can't pay, this is a very strong reason for courts to pierce the veil and go after your personal assets.

With an LLC, members typically can only be held liable to the extent of the money they put into the company: their "contribution." But if a lawsuit presses a claim against the company, and the court pierces the veil, every member can potentially be in jeopardy, regardless of which member may have created the situation.

Follow the rules

If you're in business as a sole proprietor or with other people in a general partnership, your personal and business assets are commingled. There's nothing wrong with this. But if you seek to keep business and personal assets separate, for example, to try to protect spousal income or your home from the vagaries of business and collaborations, then you have to be diligent.

When in doubt, seek professional legal and accounting advice. But as a basic starting position, when you form a business entity, resolve to follow the basic rules that apply going forward.

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