As with a corporation, it may be possible to pierce the veil of an LLC or LP. What this means is that if you (as a manager or member of an LLC) or your company engage in an act of negligence, gross negligence, or breach of contract, and then your business is sued, under certain circumstances the judge can set aside your company’s limited liability veil. In other words, the LLC members could be held personally liable for company debts.
Although piercing the veil of a corporation is rare enough, piercing the veil of an LLC is even more unlikely. For example, as of 2003 the state of Michigan had yet to have a single case where an LLC’s veil was pierced. In fact, at the time of this writing, only a handful of LLC’s have been pierced nationwide. This is partially because an LLC has far fewer (or no) required formalities to observe than a corporation. Another reason is by law as few as one person or entity can have complete control of the company. This diminishes the effectiveness of any attempt to pierce an LLC via the “alter-ego” a.k.a. domination theory, which we’ll discuss shortly.
The most important thing to remember is that you’re the one who decides whether your LLC is at risk of being pierced. Follow a few simple rules and you should never have to worry.
The Three Criterion for Piercing an LLC, LP, or Corporation
To examine how a company is pierced, we must first examine how a corporation is pierced, since corporate law is where the doctrine of piercing the veil originated.
Many years ago, attorneys began successfully arguing that the protective veil of a corporation should be set aside if the corporate form is abused. There are three ways a corporation can be abused, of which a certain court case, Garcia v. Coffman (124 N.M. 12, 946 P.2d 216 (N.M.App. 06/17/1997), gives a helpful overview. In this case, the three criteria for piercing the corporate veil are identified as Instrumentality or Domination, Improper Purpose, and Proximate Cause. Let’s examine each criterion.
Instrumentality or Domination
Instrumentality or Domination is also common known as the “alter-ego” theory. (One should note, by the way, that the term “alter-ego” sometimes collectively refers to any theory under which a limited liability entity’s veil is pierced.) The argument goes that if the limited liability entity is merely treated as an extension of a single person, to the extent that the entity and individual’s activities are practically indistinguishable one from another, then the entity and individual should be treated as a single individual with no limited liability. In other words, the entity is “dominated” or used as an instrument for a sole individual’s purposes.
One nice thing about LLCs is that by law they can be owned and/or managed by a single person. In other words, they are designed by law to be (in some ways) “dominated” by a single person. It is the author’s opinion that the Instrumentality or Domination theory is thus less effective against an LLC. However, that doesn’t mean an LLC member should ignore the dangers of a possible alter-ego ruling. To be safe, an LLC should still be treated as a separate entity from its owner. It should have a separate bank account, and LLC property should be titled in the LLC’s name instead of the owner’s. Furthermore, LLC property should not be commingled with non-LLC assets. Using an LLC bank account to buy groceries for yourself, for example, is a big no-no. For more information on how to eliminate the risk of an alter-ego ruling, see PF Shield’s Guide to Properly Documenting Business Activity.
Improper Purpose
Defining Improper Purpose is simple: if a corporation or LLC is used to commit a fraud, injustice, or wrong, it shouldn’t protect its owners from liability. In other words, don’t use a limited liability entity to defraud or otherwise take advantage of someone, and then expect the entity to protect you.
Proximate Cause
Proximate Cause simply means there must be a reason to sue the entity. If there is no Proximate Cause, then Instrumentality, Domination, or Improper Purpose theories cannot be used. There must be some tort or contract dispute that the entity is a direct party to. This why a “safe” LLC (one that isn’t exposed to potential liability, such as an LLC that merely holds investments) has a much smaller risk of having its veil pierced.