When I meet with clients for the first time they usually tell me they want to set up an LLC so that they cannot be sued personally for the company’s business. However, limited liability does not mean absolute liability. Members of limited liability companies can be liable for company debts, obligations, and liabilities for a number of reasons.
As a general rule members of a limited liability company are not personally liable for the debts, obligations, and liabilities of the company, whether arising in tort (i.e., auto accident, product liability, or a slip and fall), contract or otherwise solely because they are a member or manager of the limited liability company. Exceptions to this rule have been established by statutes and courts and some of those exceptions are laid out below.
1. Independent Basis of Liability
A member is liable for that member’s own negligent or wrongful acts or omissions as long as an independent basis for liability exists (i.e., liability does not arise solely from the member’s status as a member or manager of the company). For example, if a member is involved in an automobile accident while performing company business, the member cannot escape responsibility for damages arising from the automobile accident based on the fact that he was a member of the limited liability company.
If it’s a multiple member LLC then the other, non-negligent members would not be personally liable for those damages unless they were somehow negligent in allowing that member to operate a company vehicle. Members may be personally liable for allowing another member (or an employee) who does not maintain insurance, or that the members know to have a number of DUIIs or other driving related offenses, to operate a company vehicle.
In addition to being liable for the member’s own wrongful or negligent acts or omissions, a member is liable for any debts or other obligations that the member personally guarantees. Personal guarantees commonly accompany commercial leases and bank loans. Credit card applications commonly state that the member applying for the credit card is personally liable for any unpaid amounts. Therefore, contracts and agreements should be carefully reviewed to make sure that the member understands the liability that the member is guaranteeing and what happens if the company defaults on the debt or obligation.
2. Piercing the Corporate Veil
Piercing the corporate veil is a doctrine created by courts to hold shareholders of corporations personally liable for obligations of the company. Many states, either through case law or legislation, have extended this doctrine to apply to limited liability companies. California and Washington have enacted legislation that state that courts should apply the piercing the corporate veil case law and principles to limited liability companies.
Essentially, the test for determining whether to pierce a limited liability company’s veil boils down to whether the member, “to defeat justice or perpetuate fraud”, operates or manages the company in a way where it’s impossible to distinguish or separate the company from the member. Simply put, is the LLC the members’ alter ego?
In Oregon, to pierce the limited liability company’s veil, the party seeking to hold the members of an LLC liable must prove that the company was under the direct control of the member(s); the member(s) engaged in improper conduct; and, the party’s inability to collect from the company was the result of improper conduct by the controlling member(s). Improper conduct may include inadequate capitalization, milking the company by taking excessive or wrongful distributions, commingling assets, lack of separateness between the company and the member (use of the company’s finances to pay for personal items and bills), and failure to follow formalities dictated by statute or the operating agreement.
Failure to follow corporate formalities is not a major factor in a claim for piercing the limited liability veil since the organization, management and operation of a limited liability company is intended to be less rigid than that of a corporation. In fact, many state statutes expressly provide that a failure to follow or observe the usual limited liability company formalities is not a ground to pierce the limited liability veil. Piercing the corporate veil cases are fact specific and require extensive review of the company’s financial records, operating agreement, and organizational documents.
3. Wrongful Distributions
A limited liability company may only make distributions if the members or manager make the determination that after the distribution is made:
a. The company will be able to pay all of its debts as they come due in the ordinary course of business; and,
b. The fair value of the company’s assets would at least equal the sum of the company’s total liabilities plus the amount necessary for the company to satisfy any member’s preferential right to distributions.
The company can base its determination to make distributions on either financial statements prepared in accordance with sound accounting practices, a determination of the fair value of the company, or another method that is reasonable under the circumstances.
Liability is generally limited to the amount of the distribution received by the member. However, liability may be expanded if a wrongful distribution is used as a factor in establishing a claim to pierce the limited liability veil of the company.
Other exceptions to limited liability may apply depending on the state the company is organized in or doing business, the type of business the company is engaged in, and agreements that the members enter into during the course of business.