Part I of this series provided an overview of alter ego liability and litigation, and why the concept is the most litigated issue in corporate law, and thus relevant for business owners. This Part II provides practical tips for business owners to ensure they maintain limited liability protection. Part III will discuss related and alternative theories to alter ego liability.
Practical Asset Protection Tips
- Avoid Single-Member LLCs. Note, single-member LLCs (SMLLCs) are absolutely proper and common structures for business owners; however, SMLLCs are more susceptible to veil piercing (as discussed in Part I), and they do not have charging order protections. As company operations and assets grow, so does the potential for lawsuits. In addition to being more exposed to veil piercing, LLCs (unlike corporations) are susceptible to reverse piercing, i.e., where a creditor goes after the LLC’s assets to collect on an LLC member’s debt. With multi-member LLCs, the creditor’s piercing remedy is limited to a “charging order.” A charging order limits a creditor’s recovery to only the LLC distributions payable to that member. The remaining assets of the LLC are untouchable. This is to protect the other LLC members who are not involved in the creditor’s claims. Since a SMLLC has no other members, the need for charging order protection does not apply.
- Maintain separate bank accounts. Obtain a tax identification number for the entity and open a bank account under that EIN in the name of the company. Maintain the integrity of the business bank account, and do not comingle funds. This is a critical factor in alter ego analysis. Maintain the company’s assets separate and apart from other assets. Do not run personal expenses or pay for personal items with the business account. Investment funds and loan proceeds should be carefully maintained and used solely for the purposes received.
- Adequately capitalize the company. This is another critical factor in alter ego analysis. Courts look to see if the business is adequately capitalized to maintain operations and pay debts. If the governing agreements specify monetary capital contributions, ensure the contributions are documented in the financial records of the business.
- Protect creditors. Related to the point above, ensure the company takes all reasonable steps to protect creditors. For example, if the company has debts coming due, it should not make distributions to members if it will be unable to pay its debts. Similarly, the company should refrain from transferring assets that may expose it to claims of fraudulent conveyance.
- (LLCs vs. Corporations) Select an entity with manageable corporate formalities. LLC and corporations are two of the most common entity choices for limited liability protection. There are pros and cons for each and many issues to consider that are outside the scope of this article. Generally, LLCs are a newer corporate vehicle than corporations, but LLCs are becoming more widely accepted and used across industries. One distinct advantage between LLC and corporation in the alter ego context is LLCs are more flexible and have fewer corporate formalities. On the other hand, as discussed above, corporations are not susceptible to reverse piercing claims.
- Maintain the entity in good standing. Simply forming the entity in one state and forgetting about it is a mistake. Remember, this is a separate entity, and thus needs to be treated and maintained accordingly. If you form in a state you are not operating, make sure to qualify the company as a foreign entity in the states of operation. File any annual or bi-annual reports such as statements of information, update the statements in the event of any change of information, and pay annual fees and taxes. Also, file taxes for the entity annually.
- Prepare and follow governing documents. Certain states require particular governing documents for entities. Interestingly, some states do not require governing documents for a finding of alter ego. For instance, California does not require LLCs to maintain written operating agreements. However, regardless of whether or not governing documents are required by law, it is always best practice to maintain written governing agreements. These documents evidence separateness and provide a clear understanding of the parties. Make sure to understand and follow the procedures set for in the governing documents. For instance, if there are specific protocols for management decisions, member meetings, distributions, etc., make sure the procedures are followed and documented. Also, whether or not required in the governing documents, obtain and maintain all necessary and reasonable insurance policies appropriate for the operations of the company.
- Sign all documents in capacity of the company. If you are executing agreements on behalf of the company in the capacity of a manager, ensure all signatures identify the capacity in which you are signing. This makes it clear you are acting on behalf of the company and not individually.
- Document all transactions, especially transactions with insiders. Ensure all major transactions with third parties are documented. For example, service agreements, loans, investments, licenses, etc. This is particularly important for transactions with insiders, e.g., owners, parent / subsidiaries and affiliates. In addition to documenting the transactions, ensure fair market value consideration is provided in connection with all deals.
- Form in a state with strong corporate protections. Certain states have veil piercing laws that make it difficult for creditors to pierce, including Delaware, New York, Wyoming and South Dakota. Nevada is also protective of the corporate form and a good state for asset protection.
Consult with experienced attorneys to ensure proper formation and transactions consistent with limited liability principles. It is universally cheaper to do it right at the outset versus spending money trying to defend against veil piercing claims.
[Shahrokh Sheik is a partner in the Los Angeles office of Weinberg Gonser Frost LLP. He regularly handles business and trademark litigation and outside general counsel matters.]