The rise of the limited liability company as the go to form of business can be partly explained by the simple benefit it provides: limited liability. But this benefit is not as simple as it may seem. In fact, there are limits to the protection provided, there are governance tasks business owners must perform to maintain the protection, and case law is slowly but steadily expanding the holes through which aggrieved plaintiffs may sneak to get to personal assets. In our estimation, the LLC is on a trajectory towards a massive increase in litigation and we suspect that plenty of LLC owners will be caught unprepared.
Limited liability protection (the “shield”) is best explained by what it does not do for owners. Here are five myths that will get business owners in trouble if believed:
- 1. The get-out-of-jail-free myth. The limited liability shield does not eliminate or reduce a legal liability. It separates assets within a company from assets outside the company. If an LLC loses a lawsuit and faces a judgment, it is obligated to satisfy that judgment from its assets.
- 2. The hide-the-ball myth. The LLC is subject to the same creditor’s rights protections against fraudulently transferring assets to hide them from known creditors. In short, once an LLC ‘creates’ its legal problem, the assets in the company are at risk. Assets that are outside an LLC at the time they become exposed to a potential creditor cannot be shielded by suddenly moving them into an LLC.
- 3. The impenetrable fortress myth. Like the first myth, the shield has been oversimplified in that it is perceived as a watertight legal tool. In reality, the LLC shield is modeled after the protection corporate shareholders enjoy. If shareholders treat their corporation carelessly and disregard governance formalities, creditors can ‘pierce the veil’ and go after personal shareholder assets. The same vulnerability applies to llc’s but with the unfortunate reality that their informal nature invites the kind of careless management practices that undermine the shield.
- 4. The offensive use myth. The shield is only a defensive tool and it can only be used against liability threats aimed at the company itself. In many situations, usually involving tort law, the action giving rise to a liability is attributable to both the company and an individual actor, such as an owner. The lawsuit will name both the company and the owner individually. The company’s liability shield will not insulate the owner’s personal assets in such a case. Beyond tort cases, many contracts involve a personal guarantee, the purpose of which is to explicitly get past the shield in search of assets.
- 5. The filed and finished myth. Forming an LLC is incredibly simple, and involves little more than 90 seconds and $99 credit card charge in Ohio. Unfortunately, this minor technical step isn’t all that is required to properly establish the company. Business owners must treat the LLC as a proper, separate legal ‘person’. This requires separating assets and bank accounts, and not using the company for personal affairs and vice versa. Governance records should be kept to demonstrate this proper treatment. While the LLC allows owners to get by with less formality, the complete absence of company record books and basic governance processes is a good way to erode the shield.
This last myth is perhaps the greatest source of potential trouble for LLC’s in the future. It is very easy to get comfortable in lax operating habits – chaotic management, commingled finances – and years can go by before it ever becomes an issue. But once it does though, it is too little too late, and retroactive corrective measures won’t fix the leaky hole.
It’s a big gamble to think you have protection only to learn you don’t. Keep your company in good shape and your personal assets safe by not falling for these myths!
Tim Schirmang, founder of the Schirmang Law Practice, helps small businesses with formation and structuring, intellectual property, commercial agreements and property leases. The practice also helps clients with business succession and estate planning. www.3406erie.com