While the formation and structure of an LLC can be quite rewarding to its members, the proper operation and management of the LLC is not without its perils and requires careful forethought. It is never too early to consider the management style of the LLC, and the style and strategic goals should be reflected in the Operating Agreement and the structure of the LLC. As flexible and organizationally moldable as an LLC is, it is imperative that the selection of key management goals is outlined, the empowerment of certain members is delineated, and the income distribution and taxation goals be stated, as soon as is possible. In addition, care must be taken by the Managing Member to ensure that the integrity of the LLC’s separate entity status is maintained, thereby safeguarding its tax position and the limited liability protection afforded it’s members. The LLC manager can use the company to operate nearly any business from a private equity group to a pawn shop.
Much in the same manner that Corporations can be subject to a piercing of the corporate veil by outside agencies or adverse parties in a lawsuit, the LLC can be bereft of the corporate protection if the LLC status is jeopardized because of mismanagement or misappropriation of its funds or assets. The manner in which to lose this protection is very similar to that which a standard Corporation loses its veil. If, for example, a court of law deems that the members acted in such a way that company funds were treated as their own, or if the LLC was a de-facto shield for tax evasion purposes, or if the corporate form was abused or completely disregarded by the members, then they would be considered to have lost their LLC status and would be subjected to having the LLC veil pierced. In addition, the court can also invoke the doctrine if it feels that the LLC was managed or dominated in such a way that it was wielded in order to inflict an injury, fraud, or an injustice against an outside individual, group, or organization.
It is the Managing Member’s prime directive to ensure that none of these things occur at any point during the formation or operation of the LLC. Although no proper “Corporate Formalities” apply to an LLC, the courts nonetheless expect the LLC to be managed within the parameters of a “corporate form,” with some basic premises and understandings.
There are very important points that must be considered in order to effectively manage an LLC:
- Executing an Operating Agreement and preserving its integrity. This is the agreement that governs the operation and management of an LLC, and is the closest thing to a Corporate Formality that an LLC experiences. This is the place where all of the distribution, taxation, and goals of an LLC should be clearly outlined so that there is no question of intent as to each of these points. This is also the place where any special privileges to key members are outlined.
- Ensure that there is adequate capitalization for the formation, operation, and maintenance of the LLC. This is another management area that comes under close court scrutiny whenever the LLC status is brought into question. Inadequate capitalization may reek of fraud to the court and may lead to a piercing of the LLC veil. It is the Managing Member’s responsibility and directive to ensure that LLC funds are properly managed, and that there is no misuse of funds or excessive or unnecessary depletion of assets by the members. Improper use of funds or leaving not enough operating capital in the coffers is a sure-fire way to attract untoward regulatory or court attention and lead to a piercing of the veil.
- The Managing Member should ensure that there is absolutely no Co-mingling of funds. This means that in no way should any of the LLC funds be used for personal purposes or advantage by members, nor should members be directly responsible for the payment or guarantee of an LLC debt or financial obligation. Any form of personal use of corporate funds or assets will most assuredly lead to an alter-ego interpretation by the court or regulatory agencies which inevitably leads to a loss of LLC status and all the protections afforded by such status.
- All Members should adhere to the principles outlined by the Operating Agreement, and understand that all official actions on behalf of the LLC should be applied against a “in the best interest of the LLC” standard to ensure that there are no personal agendas proffered at the expense of the health of the LLC. Any actions to the contrary can also lead to an alter-ego determination by the court and result once again in the piercing of the LLC veil.
Taxation is another area where effective management can lead to successfully taking advantage of all of the tax benefits afforded the members. The avoidance of excessive taxation is one of the important reasons companies choose to incorporate as LLCs, and it is of prime importance that these benefits are safeguarded through an effective Operating Agreement and efficient management. It is in every member’s interest that these benefits are preserved through effective and efficient management.
Having a proper management plan, and authoring a thorough and effecting Operating Agreement, will go a long way towards ensuring the prosperity of an LLC, and selecting a like-minded Managing Member is the best place to start.
Improperly Managing an LLC
In order to illustrate how these issues may effectively reduce or eliminate the protection from liability that is afforded by an LLC, let’s examine a couple examples:
- LLC Management Example - Co-mingling Funds
John agrees to invest with IInvest LLC, of which Simon is the sole member. Under the investment agreement, IInvest LLC establishes an investment profile with 45 days duration, in which John is to recover his investment, plus a 25% bonus.
Simon, as the sole member of the IInvest, is not properly capitalized. Simon resorts to taking loans on his home in order pay for LLC expenses rather than simply loaning the money to the LLC and issuing a promissory note. He also issues LLC checks for his personal expenses and pays for LLC operating costs from his personal account without reimbursing himself or having a promissory note from the LLC to reimburse himself in the future.
At the end of the duration, John demands his capital investment plus the 25% bonus that was agreed to. Simon is unable to pay the capital and files for bankruptcy protection for his LLC.
In the ensuing court proceedings, John will most likely succeed in piercing the corporate veil and can begin to recover his losses from Simon’s personal assets, including his home, investments, back accounts, vehicles, etc.
- LLC Management Example - Liability Protection
Tony is the only member of SpeedyService LLC, a local package delivery service. SpeedyService LLC's balance sheet shows a net worth of $50,000. Unexpectedly, Better Delivery Corp. opens its doors next to Delivery LLC which causes the market for SpeedyService LLC’s services to dwindle. The net worth of SpeedyService drops sharply. Tony is unwilling to add additional capital, and the company soon goes out of business.
Jack, who lives in the same city in which SpeedyService LLC does business, is hit by SpeedyService LLC's truck while jogging. Jack brings a suit to pierce the LLC veil of SpeedyService LLC.
Under this scenario, Jack may try to pierce SpeedyService LLC's veil in order to reach Tony’s personal assets.
The application of the doctrine to pierce the veil in this manner, whether in the LLC or corporate setting, is considered a drastic remedy by most courts, particularly in instances where the owner is an individual as opposed to another business entity. Accordingly, a court will only in rare circumstances, and after much deliberation, resort to this remedy. It is also important to note that it is perfectly legal to form an LLC to avoid personal liability. Naturally, what will expose the owners is using this financial shelter to engage in criminal activity.
Members of an LLC can manage these risks by ensuring that they have a complete and proper management plan in place in the form of a well written and articulate operating agreement. They should ensure that personal business and financial affairs are maintained separate from the LLC, that personal assets and funds be maintained separate from the LLC, and that there is always adequate capitalization in order to ensure the proper operation of the business.
Each member’s ownership percentage should be clearly delineated in the operating agreement, along with any enhanced ownership rights or authorities granted to any one owner. Profit and bonus distribution should also be properly outlined in the operating agreement, along with the members’ annual draw or salary. If there are non-member employees of the LLC, their duties, rights, and responsibilities should also be a part of the operating agreement and properly listed within.