Protecting Yourself from Yourself and Others: 5 Mistakes and Tips to Avoid the Dangers of a Sole Member LLC
By Kyle D. Winey, Esq. and Robert Showers, Esq.
Owning a for profit Sole Member Limited Liability Company (LLC) can be beneficial, but it can also be risky. It is risky because owners subject themselves to common mistakes that jeopardize the legal protections that LLCs are meant to afford. Sole member nonprofit Limited Liability Companies (SMNPLLC) can also get their tax-exempt status from the tax-exempt sole member. They have similar issues to the ones discussed below, but with distinct differences.
Fundamentally, LLCs are distinct entities from their owners. Because LLC owners and the owners themselves are separate, courts generally cannot garnish or levy assets of the LLC’s owner in legal disputes. However, if a business owner makes certain mistakes, courts may seize the owner’s personal assets. This type of ruling is called “piercing the veil” and it can financially ruin a business owner.
- SURPRISE
In June 2010, the Supreme Court of Florida sent shivers down the collective spines of attorneys and estate planning experts everywhere in deciding Olmstead, et al. v. Federal Trade Commission, 44 So. 3d 76 (2010). The question presented in Olmstead was “[w]hether Florida law permits a court to order a judgment debtor to surrender all right, title, and interest in the debtor’s single-member limited liability company to satisfy an outstanding judgment.” Olmstead at 78. In answering the question, the Court allowed a judgment creditor to levy the membership interest of a judgment debtor in a single member limited liability company (“LLC”), sell the underlying assets of the LLC in partial satisfaction of the judgment, and dissolve the LLC. Does this decision spell the end of the liability protections afforded to the member of a single-member LLC or to the members of a multiple member LLC? Not in the Commonwealth of Virginia.
The appellants were found to have operated an “advance-fee credit card scam” through their various entities, and the FTC obtained injunctive relief and a judgment of more than $10,000,000 in restitution from the appellants. Id. To partially satisfy the judgment, the FTC obtained an order from the District Court compelling the appellants to endorse and surrender their membership interest in certain single-member LLC’s. Id. On appeal, the United States Court of Appeals for the Eleventh Circuit certified the above referenced question to the Supreme Court of Florida.
The Supreme Court of Florida analyzed the Florida Limited Liability Company Act, Chapter 608, Florida Statutes (2008) (Hereafter, the “Act”). The Court determined that, while the Act grants a judgment creditor the right to access the judgment debtor’s profits and distributions from an LLC in which the judgment debtor is a member (i.e., a charging order), such right is not the sole and exclusive remedy for a judgment creditor with respect to the judgment debtor’s membership interest in the LLC. Id at 83. The Court found that Section 56.061, Florida Statutes (2008), provides an additional remedy to the judgment creditors, specifically, that a judgment debtor’s membership interest in a single-member LLC is subject to levy and sale under execution. Id. The holding issued in the Olmstead case was that “a court may order a judgment debtor to surrender all right, title, and interest the debtor’s single-member LLC to satisfy an outstanding judgment.” Id.
The Olmstead case could make any attorney or estate planning expert nervous; however, such nervousness is misplaced in the Commonwealth of Virginia and other states with similar laws. A charging order can be a useful remedy for a judgment creditor to access profits and distributions which would otherwise flow to a judgment debtor as a member of an LLC. A charging order alone does not give the judgment creditor the right to manage the LLC, vote the membership interest or exercise any other incidents of ownership of the LLC. The judgment creditor simply steps into the “economic shoes” of the judgment debtor. By allowing the membership interest of a single-member LLC to be subjected to levy, the Supreme Court of Florida allowed the judgment creditor to sell the underlying assets of the LLC in partial satisfaction of the judgment and dissolve the LLC. In the wake of Olmstead, it appears that a single-member LLC organized in Florida no longer protects the assets of the LLC from judgments against the LLC’s single member.
- Each state has different laws that apply.
Fortunately, for members of LLCs organized under laws of the Commonwealth of Virginia, the General Assembly was one step ahead of the Olmstead Court. In 2006, it took the actions necessary to prevent a similar result for an LLC organized under the Virginia Limited Liability Company Act, §§ 13.1-1000, et. seq., by enacting Section 13.1-1041.1(D). This section of the statute states:
“The entry of a charging order is the exclusive remedy by which a judgment creditor of a member or of a member’s assignee may satisfy a judgment out of the judgment debtor’s transferable interest in the limited liability company.”
The foregoing statute provides that a charging order is the exclusive remedy available to a judgment creditor with respect to the membership interest of a judgment debtor who is a member of an LLC, and is applicable to a single-member LLC or a multiple-member LLC organized in the Commonwealth of Virginia. The remedy of levy and sale and the resulting ability to reach an LLC’s underlying assets are not available to the judgment creditor with respect to the membership interest of a judgment debtor.
Therefore, while it appears that the protections afforded by a single-member LLC are not what they once were in states like Florida, Maryland, and Colorado (see In re: Ashley Albright, 291 B.R. 598 (2003)), in the Commonwealth of Virginia, an LLC remains a viable option to shield the assets of the LLC from judgments against the individual member or members. In the event of a judgment, such member’s profits and distributions may be subject to a proper charging order, but that is the extent of the risk to the member. Importantly, the assets of the LLC remain shielded. However, there are common mistakes made in forming and running a for profit or nonprofit sole member LLC.
- Mistakes and Tips.
By understanding the following five common mistakes of sole member LLCs, and following three simple steps to avoid them, your Sole Member LLC will be more financially secure and better positioned to succeed.
Mistake 1: Violating the “alter ego” doctrine.
The alter ego doctrine states that business owners are only protected from liability if the LLC and the LLC’s business owner are functionally and practically distinct. If an LLC simply serves as an owner’s alter ego, the LLC does not project the owner from liability. The court must see a clearly demonstrable and distinct line between the LLC and the LLC owner.
This becomes a problem when owners fail to make meaningful distinctions between the actions of the LLC and the actions of the LLC’s owner. For example, if a court reviews the LLC’s bank statement and finds that the LLC bank account was regularly used to pay the owner’s water bill, the court may hold the LLC’s owner personally responsible for the LLC’s legal issues.
As a result, an owner should not withdraw money for family events or personal matters on a whim. Also, LLC owners should not operate without a formal operating agreement discussed below, the agreement that provides the LLC’s policies and procedures. Suppose that you want to withdraw money from your LLC bank account and deposit the money into your personal account. The best practice is to write a check payable to you from the LLC bank account. Yes, a physical check. Then, cash the check and deposit the LLC monies into your personal account.
Do not transfer money regularly and casually between the LLC account and your personal accounts. If the LLC’s legitimacy as a separate entity ever comes into question, the courts need to be able to see that the owner’s personal finances are distinct from that of the LLC. Comingling assets is to be avoided.
Mistake 2: Forming an insolvent business
For liability protection to apply, an LLC must be solvent when created, meaning that it must have a reasonable amount of money in the bank relative to the risk of its operations. For example, suppose an LLC was formed to provide heavy construction services, but the LLC was formed with only $5.00 in the bank. If a crane operator at the construction company injures someone the day after the LLC’s formation, the court may find that the LLC owner is personally liable. Solvency issues are a way to jeopardize the liability shield that LLCs are meant to provide.
Mistake 3: Fraud
Fraud will likely cause a court to pierce the LLC veil. The legal argument here is straightforward. The court assumes that an LLC owner is not employed by the LLC to defraud others. Thus, any fraudulent behavior will be viewed as stemming from an individual actor rather than the company itself, and the actor’s personal assets may be garnished or levied.
Fraud frequently becomes a problem in situations where a product is marketed in a fraudulent manner. This goes beyond what might be described as “puffery,” or merely marketing a product’s strengths and downplaying its weaknesses. For the courts to find an owner guilty of fraud, the owner would have had to intentionally lie about the product or knowingly make false promises.
Here are some tips for successfully running a single member LLC and maintaining the liability shield that an LLC offers.
Mistake 4: Have a clear operating agreement and run your business in accordance with your operating agreement.
An operating agreement outlines the rules, regulations, and provisions of a business. Think of an operating agreement as a contract: they are binding and must be followed. While Virginia does not technically require an LLC to execute an operating agreement, having one is a practical necessity. An operating agreement will be the initial document a judge looks at in a lawsuit. Step one is to make sure that your LLC has an operating agreement. Step two is to make sure that your LLC had a good operating agreement.
As a sole member, there is often the temptation to venture outside the plain language of the operating agreement, particularly when it comes to transferring money between bank accounts. If you want flexibility in your operations, that’s fine, but be sure that your operating agreement has equally flexible language. Most of all, be sure to avoid drafting a fancy operating agreement, but then failing to follow it. You want to do everything in reason to stay within the confines of the operating agreement.
In addition, keep a company record book with meeting minutes and banking information. Maintaining this level of formality, even in situations where it seems unnecessary, will help the court understand the difference between you and your company.
Mistake 5: Corporate formalities must be strictly observed
Regardless of the choice of corporate structure, an organization, whether for profit or nonprofit, must properly maintain the subsidiary as a separate legal entity throughout its existence, or else a court may find that the organization is liable for the actions or debts of a subsidiary (or vice-versa). Such a finding by a Court is called “piercing the corporate veil” (“PCV”). Courts employ this legal device when organizations do not properly establish policies or conduct their activities in a manner that evidences they are separate entities.
Courts have not established exact tests for deciding when PCV is appropriate. They have, however, mentioned in many cases the types of behavior that will trigger a piercing. An organization and individual must be careful not to commingle funds with the subsidiary. Meaning, the different organizations and sole owners should keep separate financial records, bank accounts, and one organization’s funds should not be used for the benefit of the other.
As well, organizations must observe any formalities associated with the business structures involved. For example, if two organizations where the sole member is the operating entity, both the operating corporation and the subsidiary LLC should separately elect officers, conduct board meetings, keep independent financial records, and not have identical board members or officers. It is also recommended that there is not an overlapping board-not only board members, but definitely no more than a slim minority of board members should overlap. Officers and employees should also be separate in order to ensure the strongest shield. Moreover, the Board for the subsidiary, especially any overlapping Directors, must not appear to neglect the interests of the subsidiary in order to focus exclusively on the interests of the church. Such directors must take care to satisfy their fiduciary duty of loyalty and duty of care.
Courts have also looked to see if a subsidiary is properly financed or whether it seems designed merely to defraud any possible creditors. If a subsidiary is improperly undercapitalized courts may PCV. Also, when conducting audits, it should avoid a consolidated audit but only have a combined audit for illustrative purposes.
Summary
As should be evident from the above, a proper organizational structure is necessary to separate major assets from major liabilities. The decision as to whether to organize as for profit or nonprofit must be chosen wisely. The subsidiary structure best suited for any given organization depends on the purpose, priorities, potential liabilities, and number and size of assets. The first move is for a business, church, or nonprofit to ensure that it is properly incorporated or organized. Then, if you want to establish a connect SMNPLLC, the for profit or nonprofit organization should assess the possibility of establishing subsidiary organizations if either or both assets and liabilities are significant. The church or nonprofit should analyze whether its potential liabilities, such as active ministries connected to the church/nonprofit like a school, daycare, thrift store, seminary, etc. or legal issues like same-sex issues jeopardize its significant assets: property, money, investments, or buildings.
Once a business, church, or nonprofit realizes it needs to explore the possibility of establishing a subsidiary, it should seek legal advice from an attorney knowledgeable in corporate, liability/risk management, and tax-exempt law. A knowledgeable attorney can assist the organization in selecting the proper structure and by ensuring that the subsidiary organization and parent member are properly connected to each other in a way that complies with State law and the tax code.
By implementing these five tips, common mistakes associated with sole member LLCs, regardless whether they are a standalone or subsidiary, can be avoided.
Disclaimer: This memorandum is provided for general information purposes only and is not a substitute for legal advice particular to your situation. No recipients of this memo should act or refrain from acting solely on the basis of this memorandum without seeking professional legal counsel. Simms Showers, LLP expressly disclaims all liability relating to actions taken or not taken based solely on the content of this memorandum. Please contact Kyle Winey at kdw@simmsshowerslaw.com or call 703.771.4671 for legal advice that will meet your specific needs.
