What Every Business Owner Needs to Know about LLCs (part 2)
Creating a strong corporate veil
In the first post in this series we explored the distinction between the legal form of a business entity and the way the business is taxed. That first post is available here. We’ll now explore where LLC protection comes from, and how business owners can improve their protection.
The protection in an LLC comes from what is referred to as the “corporate veil.” In broad terms, the corporate veil is a protective barrier between the company’s operations and the business owner’s non-business affairs. It serves to prevent “inside creditors” – that is, creditors who have a claim against the company as a result of its business operations – from reaching the business owner’s assets that are not part of the company. An example of an inside creditor could be a vendor who claims the company violated the terms of an agreement. A strong corporate veil would protect the business owner’s private assets (her home, investments, etc.) from that vendor’s “inside” claim.
The corporate veil also serves to prevent “outside creditors” – creditors whose claims arise from matters that are not part of the business’s operations – from reaching into the company for satisfaction of the claim. An example of an outside creditor could be someone hurt in a car crash caused by the business owner on the owner’s personal errand (and assuming the owner wasn’t driving a company vehicle). A strong corporate veil will protect the business from that outside creditor’s claim.
This is one of the most important reasons someone establishes an LLC in the first place: to create separation from what happens in their business from things that happen outside the business, insulating both business and non-business assets from unrelated creditor claims.
How do you strengthen the corporate veil?
The level of protection in limited liability companies can vary dramatically, based on several key factors:
1. Where was the company formed?
Most business owners (or the advisors who guide them) simply form their new LLC in their home state. They assume that because business operations are headquartered in a particular state, or that the business founder lives in that state, the company must be formed there as well.
Not only is this assumption not true, it can also cause the company or its owners to have far less protection in the event of a lawsuit. Understanding the limitations in the business owner’s home state and the superior protections of other jurisdictions can mean the difference between the business surviving or failing, or the claim spilling over into the business owners’ personal assets. Some states’ laws provide very little protection for LLCs or other business forms. Knowing how to navigate those limitations and leverage better laws requires a lot of experience.
2. How good is the operating agreement?
In addition to taking advantage of a more protective state’s laws, LLCs should establish comprehensive, protective operating agreements to govern the business. Without an operating agreement, the LLC will be governed by the default provisions of the law of the state in which the company was formed. Not only does this often limit the protection for the LLC, it also means that important matters concerning the transfer of membership interests between owners, critical tax planning or company management decisions, buy-sell and valuation matters, and other essential matters end up unaddressed.
Well-designed and carefully prepared operating agreements don’t leave essential matters to chance or to the default (and often undesirable) provisions of state law. Most business owners don’t even know what the state law default rules are or that they can often be avoided.
3. Do the owners really treat the business like a “business?”
Most of the time when an LLC’s corporate veil fails, the business owners weren’t being careful enough to truly treat the business as a business. They didn’t document important business decisions, they didn’t establish compensation agreements for themselves, they used business property for personal use, and they made other critical errors in business operations.
To get the benefit of a protective corporate veil, business owners must take the business seriously. After all, if the business owners don’t respect the company, why should anyone else?
4. How is the membership equity owned?
A final consideration in protecting business equity comes in how the individual business owner actually owns their interest in the company. In addition to the corporate veil, it’s important to create a personal veil to protect valuable assets. Often, business owners will transfer their LLC membership interests to one or more protective trusts that can significantly increase the owner’s protection from both outside and inside creditors.
As with choosing the right jurisdiction for the LLC, choosing the right jurisdiction and trust structure to own the business interest takes a lot of experience, careful planning, and diligent follow through. But proper structure and attention to detail will provide a much more effective corporate veil, protecting both the company and the business owner.