Business Asset Protection – Part 1 ½

Piercing the Corporate/LLC Veil, or ‘Through the (Creditor’s) Looking Glass’?

“What It Is?”

In Part 1 of Business Asset Protection, we took up ‘Piercing the corporate (or LLC) veil.’ As we stated there,

‘piercing the veil’ … is a legal principle sometimes used by courts to ignore the normal liability shield associated with a corporation or LLC. What happens is that a creditor or claimant alleges the entity is being used for fraud or some other wrongful action affecting the creditor. If the court agrees, it might permit the creditor to satisfy its judgment against the assets of the owners of the corporation or LLC.

‘Piercing the veil’ works pretty much the same way for a corporation as for an LLC. The creditor or other plaintiff claims the entity was used to perpetrate some fraud, wrong or injustice. Then the court looks at a laundry list of factors to decide whether to allow the liability ‘veil’ to be pierced, including:

• “Shell or Zombie Entity” – Not having capital or business assets appropriate to operate the entity
• “Personal Piggy Bank” – In which the owners commingle personal and company funds or assets; or perhaps they consistently fail to deal with the entity on an arms-length basis
• “Winging It” on Transactions – Absent or inadequate company records, including minutes or resolutions (probably not as applicable to an LLC as a corporation) and also accounting records
• “Operating Agreement? What’s That?” (or Bad One) – Not having decent organic documents: LLC operating agreement or, for corporations, Bylaws and Board resolutions

The preceding factors more or less boil down to a failure to respect the corporation or LLC as a legal entity separate from the owners.

“The Curious Case of the Single Owner Company”

“But those things don’t matter if I’m a single member LLC, right?” Wrong! As one national expert on creditors’ rights put it, “single-member LLCs are fundamentally lousy asset protection vehicles.”

Why is that?? Usually, it’s because the owner did not bother to set up and run their company so as to avoid the traps listed above. So the company hasn’t been treated as separate from the owner. Often, folks just get themselves set up with the Secretary of State and let it go at that.

Lawyers Company Service, Ltd. is owned and operated by a New Mexico attorney. We will make sure you are set up correctly and point you in the right direction to help you avoid those traps.

What Is a Limited Liability Company Anyway?

A limited liability company (not ‘limited liability corporation‘) is a specific type of legal entity. It is one of the choices for doing business, in addition to corporations, partnerships, trusts, etc. Many business people seem to think it is only a kind of business registration or license, but it’s much more than that!

To illustrate, here is another question (for readers of our BIZ QUIZ post – for extra credit):
If you and your pal(s) just file your LLC online and don’t do anything further, how do you get out of the LLC or kick out an undesirable member? (Answer: You can’t! You are basically stuck, unless everyone in the LLC agrees to that action. That’s why you need a good operating agreement to spell these things out.)

To get a little more into the weeds on LLCs, see ‘Business Entities’ (LLC).

"ANIMAL CRACKERS"

The business world is host to a menagerie of organizations. To get this started, let’s have a little quiz:

Which of the following is NOT a form of legal entity?
(a) Massachusetts business trust
(b) S corporation
(c) Limited liability limited partnership
(d) Joint venture
(e) All of these are legal entity forms

Besides the sole proprietorship, which is not a true business entity, the simplest – and oldest – form of business entity is the partnership. Two or more persons carrying on a business can be a partnership. Any partner may legally bind the partnership, and each partner is personally liable for the debts and liabilities of the partnership. A written agreement isn’t required but is a really good idea. There is a lot of flexibility in how the agreement can be written.

Partnerships come in several flavors: the regular, or general, partnership we described above. Then there is the limited partnership, the limited liability partnership and, yes Virginia, we have the limited liability limited partnership. Like we said, it’s quite a menagerie!

Next up is the corporation, the next oldest to the partnership. A corporation is created by filing a document called ‘articles of incorporation.’ Properly formed and run, the corporation will be treated as a separate legal entity, and the owners’ assets will not be exposed to the corporation’s debts and liabilities. Corporations have a lot of moving parts: shareholders, directors, officers, bylaws and so forth. There are more formalities attached to a corporation, compared with a partnership.

The zinger with corporations has to do with taxes. Income is taxable to the corporation; then, when distributions are made to the shareholders, the distributions also generally get taxed, albeit at lower top rate. This is the notorious “double tax” of corporations. So, what’s a mother to do? Well, to the rescue comes the S corporation election: when filed with the IRS, this election magically converts the corporation to an ‘S corporation.’ When that happens, the corporation no longer pays tax separately; instead, everything is passed through to the shareholders, and they pay the tax. (The S election is only available to certain small, simple corporations.)

So, you have the partnership with its great flexibility of structure but potential liability of the partners. And you have the corporation with its fairly rigid structure but limited liability of the shareholders. Wouldn’t it be nice if there were a happy medium of those two? Well, beginning a few decades ago, there came to be the limited liability company, which combines those two favored attributes. Like the corporation, the LLC is created by filing a document. What’s more, beginning around 1988 the limited liability company was able to achieve pass-through tax status, like the partnership and the S corporation.

Alright, this has gone on too long as it is, so we’re going to stop there. But there will be future articles on pass-through entities and their tax features. Oh, so what is the answer to the quiz? It’s (b) the S corporation – not a separate legal entity, but rather a tax status obtained by a filing with the IRS.

Hungry for more crackers? See our Business Entities 101.

Why Form Your LLC in New Mexico?

This is America and you have a choice to form your LLC or corporation in any state. Certain states like Nevada and Delaware do offer specific corporate/LLC law and tax advantages. But most of these advantages are not useful to the very small businesses that are just starting out.

Most experts advise forming the business entity in the state where the business is based. Otherwise, you have to turn around and qualify to do business in that state. That can involve paperwork and costs similar to those of forming in the home state to begin with.^*

That being said, why form the company in New Mexico? For LLCs, the practical advantages of New Mexico include:

• Cost – the basic filing fee is $50 (expedited processing costs and extra $100 or $150, as the normal turnaround time is 10-15 business days).
• Relative ease of formation – there is only a simple filing with Secretary of State (online filing is available for LLCs, but there are traps and drawbacks to this option).
• Privacy or “Anonymity” – the name and address of the member(s) and/or manager(s) are not required, except for online filings. This is the “anonymous” feature of NM LLCs, a benefit that is highly touted but probably exaggerated (anyone who wants to find out the identity of the owner(s) badly enough has other ways of doing so).
• No annual reporting – unlike corporations, NM LLCs do not file periodic reports (and pay fees) with the Secretary of State, as they do in most other states.

If you think forming a New Mexico LLC or corporation is right for you, please visit our website where you can also arrange a brief Q&A conversation with a NM attorney at no charge.

^*There may be exceptions for a pure investment or title holding company, as those activities may not be considered ‘doing business.’ The same goes for online and other interstate commerce businesses – these may not have to qualify if they don’t have a physical presence in the state.

Business Asset Protection

Does It Really Work?

When you are starting a business, you may read about setting up a business entity through which you will conduct your business. One of the big reasons for doing so, you read, is to protect your personal assets from exposure to potential liabilities and claims involving the business.

Many folks starting out will set up a corporation or a limited liability company (LLC) to house the business.

In that context, there are two main areas of concern for protecting assets – the assets of the owner or owners of the business entity and the assets held within the entity itself.

In this post, we’ll consider the first area – protecting the assets of the business owner(s)

Protecting Owners’ Personal Assets – aka ‘Piercing the Veil’

What Is It?
You’ve probably heard about the concept known as “piercing the (corporate) veil.” But what exactly is ‘piercing the veil’ and how does it work?

The basic “black letter law” is that the owner or owners of a corporation or LLC are not liable for the debts of and claims against the entity. This is the liability “veil” or “shield” of the entity. ‘Piercing the corporate (or LLC) veil’ is a legal principle sometimes used by courts to ignore that liability shield. What happens is that a creditor or claimant alleges the entity is being used for fraud or some other wrongful action affecting the creditor. If the court agrees, it might permit the creditor to satisfy its judgment against the assets of the owners of the corporation or LLC.

When Would a Court Permit It?
Courts look at various factors to decide whether the “veil” should be pierced. The key factors include:

• Is the entity under-capitalized for the type of business conducted?
• Has the owner mixed up the finances of the business with the owner’s personal finances?
• Does the documentation for the business entity look adequate?

The common theme that runs through all of the factors is this: Is the LLC or corporation truly a separate entity from its owner(s) – or is the distinction blurred?

Sadly, many if not most owners do not take proper care to maintain the distinction.

The Shaky Status of the Single Owner LLC (or Corporation)
Now here is another key point: if the corporation or LLC has only one member or shareholder, it may be easier to see whether the entity’s documents and activity have been kept separate from that of the owner. And in many cases, the answer will be ‘no’. That leaves the single-owner entity more vulnerable to a piercing-the-veil attack.

[In the next post, we will look at what, if anything, can be done to “plug the holes” in single member LLC shield. We’ll also consider the ins and outs of protecting the assets of the business, as opposed to those of the owner.]

“TAXING QUESTIONS”

Do I Need a (new) EIN?

We are frequently asked whether an EIN number is needed for a new LLC or corporation. For any who don’t know – or have forgotten – the acronym ‘EIN’ stands for “Employer Identification Number.” Sometimes it’s also referred to by the more generic term “Taxpayer Identification Number” or TIN.

There is IRS guidance on this topic, but reading it may make your head spin a bit! So let’s boil it down to a few points that are easy to understand.

Corporation. We’ll get the easy one out of the way first. A corporation (including an S Corp) always needs its own EIN, because among other things, you will always be filing a separate tax return (Form 1120 or 1120s) for the corporation.

Partnership/LLC. For a similar reason, a partnership also needs its own EIN, also because it files a separate tax return (Form 1065). This also goes for most LLCs with more than one member, as they will usually be taxed as partnerships.

Sole Proprietorship. When you’re just in business for yourself, with nothing more, you usually won’t need an EIN unless you will have one or more employees.

LLC. That leaves the limited liability company with only one member (owner), the single member LLC or SMLLC. This entity can be taxed in one of two ways. First, it can be a corporation (including S corp) for tax purposes, if the owner so elects; as such it needs an EIN, as mentioned above. Or, if the owner does not elect that, it is classified as a ‘disregarded entity,’ meaning that it is not considered a taxable entity separate from the owner’s tax status. As a disregarded entity, the SMLLC is treated like a sole proprietorship and generally needs no new EIN unless it will have employees.

The following handy chart summarizes the concepts and rules covered above:

A similar question comes up where a sole proprietor with an EIN incorporates or forms an LLC for the business: Is a new EIN needed here too? We’ll look at that question and how to obtain your EIN in the next installment.