Member Avoids Personal Liability for LLC's Withheld Taxes
An LLC member ordinarily is not liable for the debts and liabilities of an LLC simply by virtue of being a member. E.g., Wash. Rev. Code § 25.15.125; Or. Rev. Stat. § 63.165. Many states, however, impose personal liability for unpaid taxes on those within a business who have authority for paying taxes withheld from employee wages, or for paying sales taxes collected from customers. If one of those statutes applies, being a member of the LLC will not shield the employee, manager or officer from the statute’s reach.
Kelly Haugen, a 10% member of an Oregon LLC, was assessed liability by the Oregon Department of Revenue for the LLC’s failure to pay Oregon income taxes withheld from employee wages. Haugen v. Dep’t of Revenue, No. TC-MD 100052C, 2011 Ore. Tax LEXIS 187 (Or. T.C. Apr. 26, 2011). The LLC was manager-managed, and Haugen was not the LLC’s manager. Haugen occasionally signed checks for the LLC, and a form filed by the LLC with the state indicated that Haugen was responsible for hiring and firing employees. Id., at *2-3. The Department of Revenue asserted liability against Haugen because of his part ownership of the LLC and because he signed checks for the business. Id. at *6.
Oregon requires employers to withhold and pay Oregon income taxes from wages paid to employees. Or. Rev. Stat. § 316.167. Personal liability for unpaid tax withholdings is imposed on “[a]n officer or employee of a corporation, or a member or employee of a partnership, who as such officer, employee or member is under a duty to perform the acts required of employers by ORS 316.167 ….” Or. Rev. Stat. § 316.162(3)(b).
Finding a paucity of case law on the liability of LLC members, the Haugen court analogized Haugen’s status to that of a corporate officer for the purpose of determining liability. Haugen, 2011 Ore. Tax LEXIS 187, at *6. The court applied prior Oregon case law involving corporate officers, and found that Haugen would be liable if he had the actual authority and control to pay or direct payment of the tax withholdings. Id. at *7. The evidence indicated that Haugen did not have authority to unilaterally sign checks or make important financial decisions – he had authority to sign checks only under the direction of the 90% owner and manager, after obtaining specific consent to sign each check. Also, Haugen did not have general authority as a member, because the LLC was manager-managed, and Haugen was not a manager.
The court concluded that because Haugen “was not in a position to pay the withholdings or direct the payment of the withholdings at the time the duty arose to withhold or pay over the taxes,” he was not an “employer” under Or. Rev. Stat. § 316.162. Haugen, 2011 Ore. Tax LEXIS 187, at *11-12. The court therefore canceled the Department of Revenue’s Notice of Liability against Haugen.
Kelly Haugen escaped liability for the unpaid taxes because of his lack of authority. Had his been a member-managed LLC, or if he had had discretion to sign checks without prior approval, the court presumably would have upheld the tax assessment against him.
Many of the comparable statutes from other states are at least as strict in finding managers and check signers to be personally liable for failure to pay tax withholdings and sales taxes over to the state. The strict approach is not surprising, given that in these cases the business has in effect been a tax collector for the state and (at least in the state’s view) is holding the state’s money. The Haugen case should be a wake-up call for LLC managers and check signers to avoid the temptation of financing the business in troubled times by holding on to tax withholdings or sales taxes.
Piercing the Veil vs. Direct Member Liability in Connecticut
Claimants against LLCs often go beyond the LLC and seek recovery from individual members or managers of the LLC. They do that because in many cases, to quote Willie Sutton, that’s where the money is. The LLC may not be able to satisfy a claim, but a member or manager who turns out to be liable on the claim may have deeper resources to satisfy the claimant.
Under the state LLC statutes, a member or manager is not liable for the debts of the LLC simply by virtue of being a member or manager, but sometimes the circumstances can result in personal liability for a member or manager. Two recent Connecticut cases dealt with attempts to reach LLC members and managers.
Piercing the Veil. Last month the Connecticut Court of Appeals decided Breen v. Judge, 124 Conn. App 147, 2010 Conn. App. LEXIS 420 (Sept. 28, 2010). In 2006 Breen obtained a judgment against Patriot Truck Equipment, LLC for money loaned to the LLC. In 2007 Breen sued Judge, the managing member of the LLC, on grounds that the corporate veil of the LLC should be pierced in order to hold Judge personally liable for the LLC’s debt. The trial court denied the veil-piercing claim, and Breen appealed.
Usually an LLC is treated as a separate legal person, and its debts are separate from the debts of its members or managers. Piercing the veil is an exception that ignores the legal distinction between the LLC and its members or managers, with the result that a manager or member may be held liable for the debts of the LLC.
Connecticut law allows an LLC’s veil to be pierced under either the “instrumentality test” or the “identity test.” To pierce the veil under the instrumentality test, the plaintiff must show that (1) the defendant completely dominated the LLC’s finances, policies, and business practices, (2) the defendant used that control to commit fraud, waste or a dishonest or unjust act, or to violate a legal duty, and (3) the defendant’s conduct caused the injury or loss complained of. Breen, 2010 Conn. App. LEXIS 420, at * 7-8.
The court listed ten factors relevant to whether an entity is dominated or controlled, and reviewed the relevant factors considered by the trial court. At all times Judge was no more than a 50% owner of the LLC. The LLC was a properly formed company doing business in Connecticut. The LLC followed the various entity-related formalities, such as keeping separate books, filing company tax returns, and filing dissolution documents when it dissolved. The LLC operated a truck-outfitting business with increasing sales for each of its first three years, although it ultimately failed. Based on those factors the court found that neither the instrumentality test nor the control test was satisfied, and therefore affirmed the trial court’s decision not to pierce the LLC’s veil.
Breen is a good example of what an LLC and its members and managers should do to avoid a pierced veil and personal liability for the LLC’s debts. It’s not rocket science: have a legitimate business, properly form the LLC, keep books and records, file tax returns, don’t use the LLC’s bank account as the member’s personal checkbook, and so on.
Tort Claims. Piercing the veil is not the only way a creditor can reach the members or managers of an LLC. The Connecticut Supreme Court in August decided a case where the plaintiff raised tort claims against an LLC member: Sturm v. Harb Dev., LLC, 298 Conn. 124, 2010 WL 3306933 (Aug. 31, 2010). (A tort is an actionable, civil wrong, such as negligently or intentionally causing harm to someone. Examples include negligently causing an auto accident, fraud, and breach of a fiduciary duty. A party injured by a tort may be able to recover damages from the tortfeasor if requirements such as causation and proof of damages are satisfied.)
Harb Development, LLC built a home for Mr. and Mrs. Sturm. The Sturms were unhappy with the result and sued both the LLC and John Harb, a member of the LLC. The Sturms asserted violations of the Connecticut Unfair Trade Practices Act, negligence in the construction of their home, violations of the Connecticut New Home Construction Contractors Act, and fraudulent and negligent misrepresentation.
Harb asserted that the Sturms’ claims against him arose from his membership and management of the LLC and were fundamentally the same as their claims against the LLC. Harb pointed to Conn. Gen. Stat. § 34-133(a), which provides that an LLC member or manager is not liable for the LLC’s debts “solely by reason of being a member or manager.” He argued that therefore the Sturms were required to plead facts adequate to pierce the LLC’s veil in order to state a valid claim, and that they had failed to do so. The trial court agreed and dismissed all claims against Harb in his individual capacity. Harb, 298 Conn. at 129.
The Sturms emphasized on appeal that their claims against Harb were tort claims based on his own actions, that he was personally liable in tort despite being a member or manager of the LLC, and that therefore it was not necessary to pierce the veil to establish his personal liability.
The Supreme Court reviewed the well-trodden case law on the tort liability of an LLC member or manager. Members and managers are not personally liable for the LLC’s torts merely because of their status as a member or manager. But if they commit or participate in the tort, or direct the LLC’s tortious act, they will be liable even if the LLC is also liable. Id. at 132-33. Nowhere in the prior cases was the injured party required to show that the LLC’s veil should be pierced in order to allow recovery against a manager or member who personally participated in or directed the LLC’s tortious act.
The court found Harb’s reliance on Conn. Gen. Stat. § 34-133(a) to be unfounded. The Connecticut LLC Act only excludes liability for the LLC’s debts “solely by reason of being a member or manager.” Conn. Gen. Stat. § 34-133(a) (emphasis added). The court concluded that the statute was not intended to preclude the common-law, individual liability of members or managers who participate in wrongful conduct, and that therefore the trial court improperly denied the claims against Harb for the plaintiffs’ failure to plead the elements of a veil-piercing claim. Harb, 298 Conn. at 137-38.
Harb’s attempt to transmute the Sturms’ tort claim against him into a veil-piercing claim was imaginative, although ultimately unsuccessful. This tactic likely reflects a recognition that piercing the veil is difficult and less predictable than proving a tort claim. As the Breen court said, “Ordinarily the corporate veil is pierced only under exceptional circumstances.” Breen, 2010 Conn. App. LEXIS 420, at *9 (quoting Naples v. Keystone Bldg. & Dev. Corp., 295 Conn. 214, 233, 990 A.2d 326 (2010)). Not only are exceptional circumstances usually required, but predicting the outcome of a veil-piercing case is challenging. As Peter Oh recently indicated in the abstract to a research paper, here, “Exactly when the veil of limited liability can and will be circumvented to reach into a shareholder’s own assets has befuddled courts, litigants, and scholars alike.”
Washington LLC Member Knowingly Receives Unlawful Distribution - What's the Remedy?
The Washington LLC Act prohibits an insolvent LLC from making a distribution to a member. RCW 25.15.235(1). Either type of insolvency will do – the LLC is unable to pay its debts as they come due in the usual course of business, or the LLC’s liabilities exceed the fair value of its assets. Furthermore, a member who receives such an unlawful distribution and who knows at the time that the LLC is insolvent, “shall be liable to [the] limited liability company for the amount of the distribution.” RCW 25.15.235(2).
How does this rule play out when a third party makes a claim against the LLC? I had always assumed that in this scenario a court would allow an LLC’s creditor to assert the claim against the distribution-receiving member as well, probably by piercing the LLC’s veil. But the analysis of the Washington Court of Appeals in a recent case turned out to be a little more complex.
In Shinstine/Assoc. LLC v. South-N-Erectors, LLC, No. 39277-1-II, 2010 Wash. App. LEXIS 1976 (Wash. Ct. App. Aug. 31, 2010) (unpublished), the defendant LLC stipulated to a judgment in favor of the plaintiff Shinstine for $127,850.58. Shinstine also sought to hold the LLC’s sole member, Roger Hicks, personally liable for Shinstine’s judgment against the LLC. Shinstine claimed the LLC made an improper distribution to Hicks that rendered the LLC insolvent and therefore violated RCW 25.15.235. The trial court agreed and pierced the LLC’s veil, holding Hicks personally liable for Shinstine’s judgment against the LLC.
The Court of Appeals began its analysis with the proposition that generally LLC members and managers are not personally liable for the LLC’s obligations. RCW 25.15.125(1). The Act provides an exception, however: “Members of a limited liability company shall be personally liable for any act, debt, obligation, or liability of the limited liability company to the extent that shareholders of a Washington business corporation would be liable in analogous circumstances.” RCW 25.15.060.
The Shinstine court looked to a case that involved an unlawful corporate distribution, Block v. Olympic Health Spa, Inc., 24 Wn. App. 938, 604 P.2d 1317 (1979), rev. denied, 93 Wn.2d 1025 (1980). In Block, the court had held that an insolvent corporation’s distribution to its sole stockholder and president, who was well aware of the company’s insolvency, did not require piercing the corporation’s veil. Block, 24 Wn. App. at 950. (The corporate rule when a shareholder knowingly receives an unlawful distribution from an insolvent corporation is similar to the LLC rule: the shareholder is liable for return of the distribution to the corporation. RCW 23B.08.310.)
The court in Block refused to pierce the veil because to do so would have allowed the plaintiff to secure a preference over the other creditors of the corporation. Block, 24 Wn. App at 950. The Block court’s reasoning was persuasive to the Shinstine court: “To hold otherwise would permit creditors to get a preference over other creditors otherwise prohibited by law.” Shinstine, 2010 Wash. App. LEXIS 1976 at *12-13. The Shinstine court applied the Block rule and reached the same result on the same reasoning – it held that the LLC’s veil would not be pierced to allow Shinstine’s claim to reach Hicks.
Was Shinstine left with no recourse? Apparently not. The court stated in a footnote:
Shinstine was not without remedy. Without disregard Shinstine could have had a receiver appointed pursuant to RCW 7.60.025(1)(c), which permits any party to request appointment of a receiver after a judgment in order to give effect to the judgment. The receiver could have sought reimbursement from Hicks or South-N-Erectors’ behalf if the distribution was in violation of RCW 25.15.235(1), and then pay those funds to Shinstine.
Id. at *13 n.5. My litigation colleagues tell me that receivers indeed can be appointed under this statute, for this purpose, but counsel for the plaintiff must go to court and make the necessary showing for appointment of the receiver. Doable, but not simple.
Sometimes an LLC's Signature on a Contract Can Result in a Member's Personal Liability
Most business people know that if they want to avoid personal liability when they sign a contract on behalf of an LLC, they should use the name of the LLC and their title. A typical example would be:
ACME LLC
______________________
By: John Smith, Member [For a member-managed LLC]
But what’s the result if language in the contract states that the signing member is personally liable? In Losh Family, LLC v. Kertzman, 155 Wn. App. 458, 228 P.3d 793 (April 12, 2010), the Washington Court of Appeals recently ruled that the language in the contract can overrule the form of signature.
William and Teresa Grover formed Grover International, LLC in 2005 and shortly thereafter acquired a business. In connection with the acquisition they received an assignment of the seller’s real estate lease. Their LLC signed the assignment using a conventional corporate style of signature, as “Grover International, LLC by William Grover member.” Losh Family, LLC, 155 Wn. App. at 461.
So far so good. But the lease assignment said that the lease was assigned to “William and Teresa Grover as individuals, dba Grover International, LLC” (“dba” of course being the customary abbreviation for “doing business as”). Id. The lease assignment in fact referred five different times to the assignee as “William and Teresa Grover as individuals, dba Grover International, LLC.” Id. at 463.
In 2006 the Grovers sold their business, and the new buyer later defaulted on the lease. The owner of the real estate sued the Grovers, the LLC, their seller and their buyer. The trial court ruled on summary judgment that all defendants were liable jointly and severally, including William and Teresa Grover individually.
The Court of Appeals expeditiously determined that the language in the assignment referred to the Grovers personally and that the LLC’s signature did not limit the assignment’s imposition of personal liability on the Grovers. The court referred to the “long established principle that where an agreement contains language binding the individual signer, ‘additional descriptive language added to the signature does not alter the signer’s personal obligation.’” Id. at 464 (quoting Wilson Court Ltd. v. Tony Maroni’s, Inc., 134 Wn.2d 692, 700, 952 P.2d 590 (1998)).
The Losh fact pattern is the sort that lawyers involved in mergers and acquisitions hate to see. Inconsistent agreements tend to be disputed and to yield unpredictable results. The Losh contract was seriously inconsistent, and under one interpretation the Grovers would be personally liable for a lease obligation under a document that they signed only in a representative capacity. And indeed, so ruled the court.
Mr. Grover likely took no consolation from the court’s admonition that if he “did not want to be personally bound on the assignment, he should have insisted on the elimination of the language within the agreement that designated the assignee as ‘William and Teresa Glover as individuals’” (which ignores the balance of the phrase, “dba Grover International, LLC”). Id.
It is puzzling that the Losh court did not analyze the conflicting language in the contract as an ambiguity that would allow the admission of extrinsic evidence. The court ignored the large body of law which recognizes that an ambiguous or contradictory contract may be clarified by the admission of extrinsic evidence to determine the parties’ intent. E.g., Berg v. Hudesman, 115 Wn.2d 657, 801 P.2d 222 (1990).
The court also ignored the fact that the contract’s identification of the parties was not a completely clear statement that personal liability was intended. The contract language did not refer simply to the Grovers individually, but also referred to the Grovers doing business as Grover International, LLC, which at the time was an existing LLC. The phrase “doing business as” is usually used only for situations where a corporation or LLC does business under an alternate name. In Losh, however, the dba referred to an existing and separate entity, not just an alternate name for the Grovers.
The court’s ruling illustrates how simple inconsistencies in a contract quicken the blood of gimlet-eyed litigators and lead to arguable judicial decisions.
LLC Manager Is Personally Liable for LLC's Failure to Pay State Agency, Without Piercing the Veil
The sole manager of a Michigan limited liability company has been held potentially liable for the LLC’s failure to pay assessments due under the Michigan Agricultural Commodities Marketing Act (ACMA). Dep’t of Agric. v. Appletree Mktg., L.L.C., No. 137552, 2010 WL 841173 (Mich. Mar. 10, 2010). The case illustrates that an LLC’s liability shield is not absolute – an LLC manager can be personally liable for some types of nonpayment by the LLC.
The ACMA established the Michigan Apple Committee to carry out marketing programs funded by assessments on apple distributors. Distributors are required to deduct a portion of the purchase prices they pay to apple producers, and to hold the funds in trust and remit them to the Committee. Mich. Comp. Laws § 290.651 et seq.
Appletree Marketing, L.L.C. withheld the required amounts from its payments to apple producers in 2004 and 2005, but failed to remit those amounts to the state. The LLC instead used the funds to pay other debts, and later became insolvent and defunct. The state sued the LLC and Steven Kropf, the LLC’s manager, to recover the unpaid assessments.
The trial court entered judgment against the LLC for the unpaid amounts, but dismissed the state’s claim against Kropf on grounds that the state’s ACMA remedy against the LLC was exclusive. Michigan’s Supreme Court reversed, holding that the ACMA explicitly preserved all other lawful remedies, including claims for common law conversion and statutory conversion. The court then examined the issue of Kropf’s potential personal liability.
Under the ACWA, the funds withheld by the LLC were held intrust for the Committee. When the LLC used those funds for other purposes, it asserted dominion and control over the Committee’s money and therefore committed the tort of conversion.
To decide whether the state could pursue claims for common law and statutory conversion against Kropf, the court looked to existing Michigan law:
Michigan law has long provided that corporate officials may be held personally liable for their individual tortious acts done in the course of business, regardless of whether they were acting for their personal benefit or the corporation’s benefit.
Appletree, 2010 WL 841173, at *7. Corporate officers may be held individually liable when they cause the corporation to act unlawfully. Id.
Kropf participated in the tort by causing the LLC to divert the Committee’s funds to other purposes. Although the prior case law involved officers of corporations, the court applied those cases to the LLC’s manager without discussion, apparently by analogy.
The court made clear that this was not a case of piercing the veil of the LLC. “However, we have never required that a plaintiff pierce the corporate veil in order to hold corporate officials liable for their own tortious misconduct, and thus it is unnecessary to pierce the corporate veil in this case.” Id.
The court concluded that Kropf could be personally liable if the facts established the necessary participation: “There is no question that, if the facts prove either common law or statutory conversion, Kropf can be held personally liable and may not hide behind the corporate form in order to prevent liability for his active participation in the tort.” Id. Because the claim against Kropf had been dismissed on summary judgment, the court remanded the claim against Kropf back to the trial court for further proceedings.
Business people use limited liability companies to shield themselves from personal liability for the companies’ debts and obligations. But the shield is not impenetrable, as Appletree shows.
Normally an LLC manager is not personally liable merely because the manager caused the LLC to breach a contract; breach of contract is not a tort. The contract, however, can establish a relationship where the conduct constituting breach of contract also constitutes a tort.
Assume the parties agree that an LLC will receive property and hold it in trust, or hold it as a bailee. If the LLC misappropriates the property and refuses to return it to the other party, it has probably committed the tort of conversion. Then, the LLC manager who caused the LLC to convert the property will be personally liable for the tort.
Tort remedies can sting. For example, under Michigan’s conversion statute, a person damaged because of another’s theft, embezzlement or conversion may recover three times the amount of actual damages plus costs and reasonable attorneys’ fees. Mich. Comp. Laws § 600.2919a.
Appletree involved an intentional tort by the LLC, but claims against managers can also occur in negligence cases. Sometimes injured parties claim that an LLC manager’s inadequate supervision and management resulted in the company’s negligent injury to the plaintiff. The law is less clear here, although in many of these cases courts do hold managers liable for acts and omissions related to supervision and management. But that’s a discussion for another day.
Another State Pierces the Veil to Reach Managers
Courts will “pierce the corporate veil” to allow creditors of an LLC to assert claims against the LLC’s owners, in a proper case. Marc Ward recently discussed just such an LLC veil-piercing case, in which the U.S. District Court for the Eastern District of Michigan upheld an LLC creditor’s claim against the single member of the LLC.
There are far fewer cases where the LLC’s veil is pierced to allow an LLC’s creditors to reach a non-member manager or officer of the LLC. I recently discussed such a case from Colorado, in which the court held that a manager could be held personally liable for the LLC’s breach of contract even though the manager was not a member, here. Sheffield Servs. Co. v. Trowbridge,No. 08CA0059, 2009 WL 1477003 (Colo. App. May 28, 2009).
Now another state court has held that an LLC’s claimants can pierce the veil and assert their claims against those involved in the management and operation of the LLC, even if the managers are not members. Equity Trust Co. v. Cole, 766 N.W.2d 334 (Minn. Ct. App. 2009).
Equity Trust was a consolidation of eight lawsuits. One hundred and seventy-eight plaintiffs sued a myriad of corporations, LLCs and individuals on theories of breach of fiduciary duty, breach of contract, misrepresentation, conspiracy, civil theft, and violations of the Minnesota Consumer Fraud Act and the Minnesota Securities Act. The plaintiffs alleged a large-scale real estate investment fraud scheme, orchestrated by the individual defendants. Default judgments were entered against the entities, and the plaintiffs sought to pierce the veil and hold the individual defendants personally responsible for the default judgments.
The court’s veil-piercing analysis considered the corporations and LLCs together, without distinguishing one type of entity from the other. The court did not discuss Minnesota’s LLC Act, but its analysis was consistent with the statute. The Act applies the corporate rules on veil piercing to LLCs: “The case law that states the conditions and circumstances under which the corporate veil of a corporation may be pierced under Minnesota law also applies to limited liability companies.” Minn. Stat. § 322B.303 (2008).
The court first applied an alter-ego analysis and found many of the alter-ego factors to be present, including insufficient capitalization, failure to observe entity formalities, insolvency at the time of the transactions, siphoning of funds by those owning or controlling the entity, and the absence of corporate records. Equity Trust,766 N.W.2d at 339. The court then examined the second prong of the test, whether piercing the veil is necessary to avoid injustice or fundamental unfairness. This prong was easily satisfied, “[c]onsidering that the entities were operated in furtherance of a large-scale real estate fraud scheme.” Id. at 340, 341.
The individual defendants argued that the corporate and LLC veils should not be pierced because the individuals were not shareholders or members of the entities. The court held to the contrary: “If veil piercing were solely dependent on a party’s ownership interest in an entity, unscrupulous parties could avoid personal liability under the doctrine by simply acting in a capacity that does not involve ownership.” Id. at 339.
Equity Trust, like Sheffield, involved non-members who dominated and controlled the LLCs, disregarded the LLCs, and used LLC funds for their own individual purposes. In both cases the courts held that in those circumstances equity would intervene and pierce the veil to avoid injustice or fundamental unfairness.
What can managers and owners of an LLC do to forestall the LLC’s creditors from piercing the veil and reaching the assets of the owners and managers? In short, follow the golden rule: If you don’t want the LLC to be disregarded, don’t disregard it yourself. Some specifics are:
- Observe the state LLC filing requirements. These usually include the initial certificate of formation, an annual report, keeping an up-to-date agent for service of process, and paying the state’s annual fee. In most states, failure to comply will ultimately result in the dissolution and termination of the LLC.
- Have a written operating agreement and comply with its requirements for meetings, approvals and other formalities.
- Keep adequate business and accounting records.
- Maintain the records required by the state’s LLC Act. For example, Washington requires that an LLC maintain at its principal place of business the following:
(a) A current and a past list of each member and manager;
(b) A copy of its certificate of formation and all amendments thereto;
(c) A copy of its current operating agreement and all amendments, and a copy of any prior agreements;
(d) Unless contained in its certificate of formation or operating agreement, a written statement of:
(i) The amount of cash and a description of the agreed value of the other property or services contributed or promised by each member;
(ii) The requirements for any additional contributions agreed to be made by each member; and
(iii) Any right of any member to receive distributions which include a return of all or any part of the member’s contribution.
(e) A copy of the LLC’s federal, state, and local tax returns and reports, if any, for the three most recent years; and
(f) A copy of any financial statements of the LLC for the three most recent years.
- Adequately capitalize the LLC. (The courts recite this factor, but unless the Company is grossly undercapitalized or the LLC Act’s limits on distributions are violated, it should not normally have much weight in contract cases, since creditors can adjust credit terms when extending credit. It may be given more weight when tort claims are involved.)
- Keep separate bank accounts for the LLC. Do not commingle personal funds and LLC funds.
Colorado Pierces the LLC Veil for Managers
Two weeks ago the Colorado Court of Appeals held in Sheffield Services Co. v. Trowbridge, No. 08CA0059, 2009 WL 147703 (Colo. App. May 28, 2009), that a manager of a limited liability company could be held personally liable for the LLC’s breach of contract even though the manager was not a member. The Colorado LLC Act provides that when a party seeks to hold a member of an LLC liable for the “improper actions” of the LLC, the court is to apply the Colorado law applicable to piercing the veil of a corporation. Colo. Rev. Stat. § 7-80-107(1). The statute does not mention LLC managers, but the court found that the statute did not preclude applying corporate veil-piercing principles to managers of LLCs as well as to members.
The vast majority of corporate veil-piercing cases involve claims against shareholders, but Colorado has previously extended the corporate veil-piercing doctrine from shareholders to directors. LaFond v. Basham, 683 P.2d 367 (Colo. App. 1984). In LaFond the defendant was not a shareholder, but he was a director, president and general manager; dictated all policy and activity on the part of the corporations; “clearly dominated both his wife and son, the only stockholders, insofar as . . . corporate matters were concerned”; and used corporate assets for his personal gain. Id. at 369, 370. The LaFond court held that on those facts, equity would not stand aside and allow valid creditors’ claims to be defeated by application of the corporate shield.
The Sheffield court extended the LaFond rule to LLC managers, adopting the reasoning of other courts that “LLC managers are similar to corporate officers or directors” and that LLCs should be treated like corporations when considering whether to disregard the legal entity. 2009 WL 1477003, at *6. The court applied to LLC managers the same rules applied to corporations: to pierce the LLC veil, the LLC must be the manager’s alter ego, to recognize the separate existence of the LLC would perpetrate a fraud or defeat a rightful claim, and to pierce the veil would lead to an equitable result.
The first condition for piercing the veil is that the LLC be the “alter ego” of the manager or member. In Sheffield the appeal was on a summary judgment ruling, so the description of the facts was sketchy. But the Sheffield court did describe the various factors relevant to whether a corporation would be viewed as the alter ego of a shareholder, and implied that they would apply to an LLC:
· The entity is operated as a distinct business entity.
· Assets and funds are commingled.
· Adequate corporate records are maintained.
· The nature and form of the entity’s ownership and control facilitate misuse by an insider.
· The business is thinly capitalized.
· The entity is used as a “mere shell.”
· Legal formalities are disregarded.
· Funds or assets of the entity are used for noncorporate purposes.
2009 WL 1477003, at *5.
The Colorado LLC Act, however, removes compliance with legal formalities from the alter ego analysis for LLCs:
For purposes of this section, the failure of a limited liability company to observe the formalities or requirements relating to the management of its business and affairs is not in itself a ground for imposing personal liability on the members for liabilities of the limited liability company.
Colo. Rev. Stat. § 7-80-107(2). The Sheffield court did not discuss this section’s applicability to an alter ego analysis, but this provision should provide some comfort for members and managers of LLCs that fail to observe all of the applicable “formalities or requirements.” Nonetheless, good business practice and a prudent approach to risk management suggest that Section 7-80-107(2) should not be relied on when establishing and operating an LLC. Practices such as keeping separate bank accounts and accounting records, properly forming and maintaining the LLC under the applicable state law, keeping records of meetings of members and managers, and properly signing contracts in the name of the LLC, are not difficult and should be used at all times.
