Limited Liability Companies and Piercing the Corporate Veil
February 9, 2016
Forming a limited liability company (LLC) is the first step of liability protection for many small business owners. An LLC protects the individual owners (referred to as members) and officers of the company from personal liability for contractual obligations unless certain events occur.
This article discusses the liability protections of an LLC, those events when members of an LLC are found to be personally liable for the company’s debts and/or obligations (called “piercing the corporate veil”), and business practices to protect from piercing the corporate veil. These contractual obligations (including company debts) can be to third parties, the entity itself, or other members of the entity. Usually, the issue at hand is a disagreement about a contract.
LLC Included in Corporate Law
While you may be thinking that an LLC is not a corporation and therefore piercing the corporate veil does not apply to LLCs, both statute and case law say otherwise. Business Organizations Code §101.002(b)(3) states any reference to “corporation” or “corporate” is interchangeable with “limited liability company,” effectively including LLCs into the piercing the corporate veil doctrine. Furthermore, case law states, “(t)hat is to say, claimants seeking to pierce the veil of an LLC must meet the same requirements as they would if the entity were a corporation.” Shook v. Walden, 368 S.W.3d 604 (Tex. App.—Austin 2012).
General Liability Protections of LLC
Forming an LLC protects its members and officers from personal liability with respect to “any contractual obligation of the corporation or any matter relating to or arising from the obligation on the basis that the holder, beneficial owner, subscriber, or affiliate is or was the alter ego of the corporation or on the basis of actual or constructive fraud, a sham to perpetrate fraud, or other similar theory.” Tex. Bus. Orgs. Code §21.223(a)(2). You, as a member of an LLC, cannot be held personally liable for any debts and/or obligations of your company, even if the company commits fraud, a sham to perpetrate fraud, or any other action to breach a contract, alone.
However, while providing a strong limitation on personal liability for members, LLC protection is not an absolute limitation on personal liability for members. The liability protection provided by §21.223(a)(2) “does not prevent or limit the liability of a holder, beneficial owner, subscriber, or affiliate if the [Plaintiff] demonstrates that the holder, beneficial owner, subscriber, or affiliate cause the corporation to be used for the purpose of perpetrating and did perpetrate actual fraud on the [Plaintiff] primarily for the direct personal benefit of the holder…” Tex Bus. Orgs. Code § 21.223(b) (bold type added) In other words, the liability protections of an LLC do not apply in certain cases when the Plaintiff can show you used the company to commit actual fraud for your personal benefit, and, when that occurs, you become personally liable toward the Plaintiff for company debts and/or obligations. This is called "piercing the corporate veil."
Piercing the Corporate Veil and its Outcomes
Piercing the corporate veil is the cause of action Plaintiffs use as a means to make a member of an LLC personally liable for the LLC’s debts and/or obligations. In the alternative, a Plaintiff that is a creditor of your personal debts may use this as a means to recover funds from your business funds or assets.
If Plaintiff successfully pierces the corporate veil at trial, you will become personally liable for the company debts and/or obligations (in the event the Plaintiff is attempting to recover a business debt or obligation from you personally), or your business would become liable for your personal debts (in the event the Plaintiff is a personal creditor attempting to recover personal debt and/or obligation.)
This could come in the form of selling personal assets such as your car; the emptying of a savings account, or, in the case of your business, any distribution you make to yourself or other members of your company may become Plaintiff’s until the judgment amount awarded to Plaintiff is secured.
Proving Piercing the Corporate Veil at Trial
Piercing the corporate veil requires Plaintiff “demonstrate that the holder, beneficial owner, subscriber, or affiliate caused the corporation to be used for the purpose of perpetrating and did perpetrate an actual fraud on the obligee primarily for the direct personal benefit of the holder, beneficial owner, subscriber, or affiliate.” Tex. Bus. Orgs. Code §21.223(b). In other words, Plaintiff (obligee) is required to show a two-part test: first, that you as the owner used the company to commit actual fraud, and second, you committed the fraud for your direct personal benefit.
There are a few common theories Plaintiffs use to show the first part of the test: “sham” theory, “alter-ego” theory, and fraud. All of these theories attempt to prove that you as the owner committed fraud. Again, this is only the first part of the test, as it is required for Plaintiff to prove the fraud was committed for your personal benefit.
Alter-ego theory is so commonly litigated factors have been listed in case law to consider with such claims: “whether the entities shared a common business name, common offices, common employees, or centralized accounting; whether one entity paid the wages of the other entity's employees; whether one entity's employees rendered services on behalf of the other entity; whether one entity made undocumented transfers of funds to the other entity; and whether the allocation of profits and losses between the entities is unclear.” Tryco Enterprises, Inc. v. Robinson, 390 S.W.3d 497 (Tex.App.-Houston [1 Dist.] 2012) These factors are not exhaustive and each alone do not necessarily prove the first prong of the two-part test, however, they may be used together to paint the picture of committing actual fraud to a jury.
Protection from Piercing the Corporate Veil
Following company formalities (paperwork) is an important first step. This includes but is not limited to annual company meetings, using your correct and complete business name when entering into contracts, and a well-drafted operating agreement. While you cannot be personally liable for company debts and/or obligations for purely lacking company formalities, it may still be presented at trial as part of the evidence for Plaintiff’s claim. A jury may see the lack of documentation as partial proof of a "sham." Furthermore, in the event a judgment is entered against you at trial, a well-drafted operating agreement will make it difficult for Plaintiff to collect the judgment awarded to them.
The operating agreement is a completely separate document than the paperwork the state requires for registration of an LLC. The operating agreement is the governing document for your company that details how the company will operate – how often distributions occur, when a member can transfer company interest to an outside party, what happens when a member dies, etc. You can file your operating agreement along with the certificate of formation, or you can keep it with your other business records.
The operating agreement adds a layer of security, another wall, between you personally and your business creditors, and can even keep judgment creditors (successful Plaintiffs) from collecting their judgment. Every operating agreement is unique in that every business has its own specific needs and the operating agreement must reflect that to be effective. Be wary of any “one size fits all” or boilerplate operating agreements because these documents will most likely be missing important clauses. Furthermore, in the event a judgment is entered against you at trial, a well-drafted operating agreement will make it difficult for Plaintiff to collect the judgment awarded to them.
On the other hand, another important step in protecting yourself from these claims is to maintain good business practices. What does that mean? Good business practices is not comingling personal and business funds and assets, not paying personal debts with company capital, and do not commit fraud through your company for your personal benefit. Basically, ensure that your personal and business accounts, debts, and obligations do not intersect each other.
Furthermore, good business practices will avoid the factors discussed in Tryco above, which entails: do not pay other entities employees, do not have your employees render services on behalf of another employer, do not make undocumented transfers of funds to another entity, and allocate profits and losses properly between entities. Proper business and asset planning and protection can avoid all of these factors.
In summation, piercing the corporate veil unties the protections woven around your business by forming an LLC. It is important to follow correct business standards and documentation to avoid this type of claim. Ultimately, you want to have such good business practices that any attempt to prove such a claim would have no merit.
-- Charlton M. Messer, Esq.
This article is for informational and educational purposes only. Please contact your Texas attorney for more information.