How to Maintain my LLC to Avoid Personal Liability
One of the biggest reasons to set up a Limited Liability Company is to avoid being sued personally by a creditor, or by a tenant if you have real estate investment property in the LLC. This protection is called a "veil" of liability protection.
Generally, a court may pierce an LLC's veil where there is fraud or where the LLC is in fact a mere instrumentality or alter ego of its owner. To establish fraud by a party seeking to pierce the veil of protection, the party must show the entity had no independent business of its own and the owner deliberately undercapitalized the entity, thereby rendering it judgment proof. But to prevail under the alter-ego theory if piercing the veil, a plaintiff need not prove that there was actual fraud and must instead use a two pronged test focusing on whether the entity operated a single economic unity with its owners and whether there was an overall element of injustice or unfairness. This analysis is fact driven, and no single category, except fraud alone justifies a decision to disregard the veil of limited protection. Rather, there must be a combination of them, and an injustice or unfairness must always be proven.
To minimize risk of piercing the veil of the company, the business of the LLC must be distinct from the individual members. "Business formalities" must be observed. The following is a checklist of what those requirements are.
1. How to Avoid Veil Piercing. Separate personal and business assets. The way to do that is avoid using corporate funds to pay personal debts, or vice versa. If audited, the IRS could determine that corporate expenses were actually personal in nature and characterized as corporate expenses in order to improperly deduct them as business expenses. Set a corporate budget to avoid the temptation of putting in your own personal money. Keep personal and corporate business as separate as possible. Don't use corporate letterhead for personal correspondence. Don't use your corporate secretary for personal business. To the extent possible, have your business operate in a separate location from your residence.
2. Observing Certain Requirements for Limited Liability Companies. Adequately capitalize your LLC so that you are not consistently adding personal funds. Maintain business records, which include tax returns, articles of organization, operating agreement, bank statements and resolutions authorizing activities. Make sure all managers, officers or directors are not nominal. Maintain adequate capital to fund anticipated transactions. Do not siphon off funds from the LLC to pay personal or other business funds. Do not commingle personal and corporate funds or assets. Try not to place all of the control of the company in one member, unless it is a single member LLC. Have a written Operating Agreement signed by all members. The Agreement should include, among other things, well defined roles for members, selection of key management roles, well outlined distribution guidelines, and operational and taxation rules. The Agreement should also include:
- an accounting model: accrual, cash, or modified cash
- record and minutes keeping
- frequency of member meetings
- management structure
- officer appointments
- buy out provisions
- any special resolutions, voting rights, or operational duties and requirements
3. Have Annual Meetings. Although not mandatory for LLCs, it will provide some evidence of business formality. Elements of the annual meeting are review and ratification of the preceding year's actions by the company, its managing members and officers, specific approval of any major decisions, recognition of any unusual events or circumstances not in the company's ordinary course of business, and election of new managers and officers who will serve in the forthcoming year. Keeping minutes of those meetings will also create a clear record of discussions, votes, and actions taken by the LLC should a dispute arise among the members. Avoid disproportionate distributions, which means adhere to the Internal Revenue Code requirements on distributions including unrealized receivables and substantially appreciated inventory. Hire a CPA to explore the appropriate tax election and ensure compliance with the tax code. Make sure to have insurance coverage at the appropriate levels. Prepare and distribute annual business and financial reports to the other members of the LLC. While this is not required, it will show adherence to business formalities. The reports should be:
- balance sheet containing information on the various financial assets, liabilities, cash-in-hand and other key factors of the finances of the business
- profit and loss statements showing the income, expenses and profit of the company
- report on the membership interests issued
- financial projections and forecast
- executive summary which may include a short message from the managing member(s) regarding the company's performance, outlook, and any other important areas. The summary would include identification of business opportunities or for growth or expansion and further identify any potential threats or issues to the business and how they are being addressed
Make business resolutions for any major business transactions like acquisition or sale of pricey assets, salary designations or raises, hiring professional third parties, expanding, relocating, hiring or firing. Issue membership interest certifications because they show ownership. Obtain and maintain all proper business licenses. Set and follow voting guidelines, which can be based on proportionate weight, one man, one vote, unanimous consent or majority. Provide for how you will vote without a meeting. Make the proper tax elections. Identify managers and delineate their roles.