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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.

Posted By: Stephanie Fallara

On: October 02, 2015

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