Many business owners establish their firm as a limited liability company (LLC) to shield themselves from personal liability in the event the company is sued. However, while the LLC structure is designed to protect the personal assets of the owners from the claims of creditors, simply filing the LLC paperwork with the state will not sufficiently shield you from personal liability. Closely held businesses must be set up and managed properly to prevent claims that “pierce the corporate veil.”
Piercing the Corporate Veil
Because an LLC is considered a separate legal being from its owners, the owners, as well as managers, have limited personal liability for the company’s debts. But in certain situations, the courts will look past the company’s LLC status and hold those who own or run the company personally liable for its debts. This is called piercing the corporate veil.
What Illinois Courts Say
Illinois law requires that two prongs be met for the corporate veil to be pierced: (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 be such that adherence to the fiction of separate corporate existence would sanction a fraud or promote injustice.
Cases are fact-specific, with courts considering many factors to determine if these prongs are met. Factors include whether there was co-mingling of the entity’s and owners’ finances, whether the entity was adequately capitalized to operate and fulfill its obligations, and whether assets were diverted to an owner to the detriment of the company’s creditors. When the entity in question is a corporation rather than an LLC, the courts will look at additional factors, such as whether certain corporate formalities were observed. Generally speaking, the courts will be looking to determine if the entity was merely set up as a sham to shield an individual or another entity and if there was an intent to defraud creditors.
While courts in Illinois are reluctant to pierce the corporate veil, it can and does happen, and it can be devastating to the individual owners, who in some cases will find themselves on the hook for millions of dollars in company debt. Setting up and managing your LLC properly can go a long way in shielding yourself from personal liability.
Co-Mingling of Assets
The owners of an LLC must maintain a formal legal separation between their business and personal finances. Co-mingling of finances could lead to a finding that the LLC is merely a sham for the owners and that the owners are therefore not entitled to the protections offered by the LLC structure.
It is important for the owners to maintain separate bank accounts for the entity. Any money coming in and out of the entity should be properly identified and accounted for and kept separate from the owner’s personal finances.
Adequate Capitalization to Meet Contractual Obligations
Generally speaking, the court presumes that a party entering into a contract with an LLC did so voluntarily, knowing that the LLC was a separate and distinct entity from its owner. Thus, the court is reluctant to pierce the corporate veil in a breach of contract case unless there was some sort of fraud or bad intent involved. The plaintiff usually must show that the LLC entered into the contract knowing it could not or would not fulfill its obligations – that the party took the plaintiff’s money but had no intent to pay the plaintiff back or provide the contracted-for products or services. An individual or a parent company may hide behind an LLC, which serves as a sort of alter-ego. The individual or parent company may never have put sufficient assets into the LLC or it may divert assets away from the LLC so that if the LLC breaches the contract, the other party to the contract will have no remedy.
Ensuring that your LLC is adequately capitalized and maintaining proper records to show this will go a long way in preventing a finding that the company served as a liability shield rather than an independent entity capable of carrying out its own business. Moreover, when doing business with a recently formed LLC, consider getting a personal guarantee from the owner to protect you in a situation where the LLC is unable to pay its debt.
Consult Legal Counsel
As previously stated, filing your LLC paperwork is not enough to protect the owners from personal liability. When establishing your LLC and periodically thereafter, it is important to consult with an experienced attorney who can advise you on setting up and maintaining business practices that will help shield you from personal liability in the event of a lawsuit against your business. And, on the flipside, if you find yourself in a contractual dispute with an LLC that you suspect is merely an alter-ego of its owner (whether that owner is an individual or another entity), remember that there are multiple avenues for relief including, but not limited to, piercing the veil of the LLC to hold its owner liable.
Novack and Macey LLP is a commercial and business litigation law firm that represents family and other closely held businesses, entrepreneurs, and other parties in disputes arising out of business relationships and commercial transactions. To contact the author, please email Yvette V. Mishev at email@example.com or call 312.419.6900.