How to Lose Your LLC’s Personal Liability Protection in Two Easy Steps

Whether you are just starting a new venture or growing your business beyond a sole proprietorship, you will inevitably reach a point where you want to ensure that your personal assets will not be vulnerable in the event that lawsuits or other liabilities confront your business. In the world of small business, there are two clear vehicles to accomplish that goal: a limited liability company (LLC) or an S-corporation (often shortened to S-corp).

As I discuss here, both LLCs and S-corps do what sole proprietorships do not, and that is remove your personal assets from the reach of your business creditors. However, if you are an Illinois LLC owner and you fail to maintain and treat the LLC as a separate entity or engage in fraudulent conduct, you expose yourself and your partners to the very personal liability for corporate obligations that led you to form the entity in the first place.

“Piercing the Corporate Veil”

“Piercing the corporate veil,” – though the concept applies to LLCs as well – is the term used to describe imposing personal liability on a company’s owner(s) for a corporate obligation. Plaintiffs often attempt to pierce the corporate veil when the company they are suing is insolvent or would be otherwise unable or unlikely to pay any judgment entered against it.

Veil-piercing allows a court to “impose liability on an individual or entity that uses a corporation merely as an instrumentality to conduct that individual’s or entity’s business.” Fontana v. TLD Builders, Inc., 362 Ill. App. 3d 491, 500 (2005)

Illinois courts use a two-prong test to determine whether to pierce the corporate veil:

  1. there must be such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist; and
  2. circumstances must exist such that adherence to the fiction of a separate corporate existence would sanction a fraud, promote injustice, or promote inequitable consequences.”

When You and Your LLC Are One and the Same

In determining whether the “unity of interest and ownership” prong of the test is met for an LLC, a court will consider many factors, including:

  • inadequate capitalization;
  • insolvency of the debtor LLC;
  • commingling of funds;
  • diversion of assets from the LLC by or to a member to the detriment of creditors;
  • failure to maintain arm’s-length relationships among related entities; and
  • whether, in fact, the LLC is a mere facade for the operation of the dominant members.

Failure to Follow Formalities Isn’t Enough

One of the reasons business owners form LLCs rather than S-Corps is that there are fewer corporate formalities that need to be followed. In some states, failure of LLC owners to follow corporate formalities can be a basis for piercing the veil.

In Illinois however, the state’s LLC Act specifically provides that “the failure of a limited liability company to observe the usual company formalities or requirements relating to the exercise of its company powers or management of its business is not a ground for imposing personal liability on the members or managers for liabilities of the company.” 805 ILCS 180/10-10(a), (c).

Failure Doesn’t Necessarily Equal Fraud

If a court finds that an LLC and its members were one and the same – “that there was a unity of ownership and interest” – it still must find that failing to pierce the veil would “sanction a fraud, promote injustice, or promote inequitable consequences.”

Simply because an LLC goes under doesn’t mean that shielding the owners from personal liability would be inequitable. Sure, it would be unfortunate for the suing creditor, but without an intent to defraud or other conduct that makes it clear that the owners were acting in bad faith, a court will not pierce the veil.

The Law Offices of Louis R. Fine

If you are an Illinois LLC owner, it is critical that you understand that the protections afforded to your assets aren’t set in stone just because you formed an LLC. I work closely with my small business clients to implement programs and protocols designed to minimize risks, including the risk of personal liability for their business obligations. If you need assistance with any small business legal matter, please give me a call at 312-236-2433 or fill out my online form to arrange for your free initial consultation.

You Need Structure: The Importance of Picking the Right Corporate Form for Your Business

Insulating Yourself from Personal Liability and Other Considerations

If you’re an entrepreneur or small business owner pouring your heart and soul into building and growing your enterprise, the dream is that all of that hard work and investment will be rewarded with success. The nightmare is that you expose your personal finances to significant risk and tax liability that can bring that dream crashing down. One of the ways to minimize those risks and protect yourself is to pick and form the right business entity.

For small businesses, this choice often comes down to two potential corporate structures: a limited liability company (LLC) or an S-corporation (often called an “S-corp”).

As alluded to above, perhaps the most fundamental reason business owners form LLCs or S-corps is to protect their personal assets from business creditors or other liabilities arising out of the operation of the business. Both of these entity types can accomplish this crucial goal, giving owners much needed peace of mind.

However, that protection can be lost if the business owners conduct their affairs in such a way as to render the company a mere “alter ego” of its owners or if they engage in fraudulent conduct. Additionally, both entities provide the benefit of treating your business income as your personal income for tax purposes.

How LLCs and S-Corps are Different

While both LLCs and S-corps provide the benefit of protecting personal assets, there are several key distinctions between LLCs and S-corps. A few of those differences include:

  • Both LLCs and S-corps are “pass-through” entities for tax purposes, which means business profits pass through the business entity and get taxed as the personal income of the owners. Here’s how it works:
    • Single Owner LLCs. If you run a single-owner LLC, you are taxed like a sole proprietorship, which means you can simply attach a Schedule C form to your personal tax return.
    • Multiple Owner LLCs. If your LLC has several owners, you can choose to be taxed as a corporation or a partnership.
    • S-Corps. In an S-corp, the corporation’s income is reported on the shareholders’ personal income taxes, based on their percentage of shares owned, regardless if they received distributions of the corporation’s income.
  • Allocation of Income. If you have others who will have an ownership share in the business, you will have to figure out how income will be allocated between you and your partners:
    • S-corps don’t give you much of a choice, as income must be distributed evenly among all owners regardless of how much labor or money each owner has contributed to the enterprise.
    • In an LLC, however, you can distribute income however you wish.
  • Corporate Formalities. One of the appealing things about an LLC is that, as a general rule, fewer corporate formalities are required than in S-corps and certainly fewer than in regular corporations. But being too casual can lead to serious problems:
    • As noted, failure to treat the LLC as a distinct entity by commingling funds, undercapitalizing the company, failing to hold meetings, etc. can result in the loss of that all-important personal liability protection.
    • While Illinois LLCs are not required to have written operating agreements, I strongly recommend that a written operating agreement be drafted and signed by all members to clarify the parties’ rights and obligations and avoid future conflicts as to its provisions.
  • Ownership Restrictions. An S-corp can have no more than 100 shareholders. By contrast, LLCs can have any number of owners and can even be owned by corporations and other LLCs.

There are numerous other nuances and distinctions regarding ownership, management, and operation of both LLCs and S-corps, and there are special types of LLCs called “Series LLCs” and “Low-profit LLCs” that may be best suited for your business. Additionally, there are other potential entities available, including general partnerships, limited partnerships, and specialized partnerships for the provision of professional services.

The Law Offices of Louis R. Fine

I understand that every business is different and that the goals and concerns of every business owner are unique. That’s why I work closely with my clients to evaluate their specific situation and determine which business structure will best set them up for success and growth. Please give me a call at 312-236-2433 or fill out my online form to arrange for your free initial consultation.