Key Takeaways

  • LLC members generally enjoy limited liability, meaning they are not personally responsible for business debts or legal claims.
  • This protection can be lost if members engage in misconduct, such as commingling funds, undercapitalizing the business, or failing to follow corporate formalities.
  • Personal guarantees, fraud, and negligent actions can also pierce the corporate veil and result in personal liability.
  • Courts consider several factors when deciding whether to disregard limited liability protections.
  • Proper insurance, an operating agreement, and financial diligence help maintain liability protection.

The liability of LLC members depends on a few factors. It's important to know this information when running your business.

What is an LLC?

A limited liability company, or LLC, is a type of business entity that is separate from its owners. It is not required to pay its own taxes, unlike a corporation, as it's a pass-through tax entity. All profits and losses from the business are passed through to the owners, who then report them on their own tax returns. This is similar to a sole proprietorship or partnership's tax structure.

Some people think LLC means "limited liability corporation, " but this isn't true. An LLC is a company and is less complex and requires less paperwork to create and run than a corporation.

Similar to shareholders in a corporation, LLC owners are not responsible for the debts and claims of the business. Creditors are not allowed to come after a member of the LLC's car, house, or any other personal possessions. Only LLC assets pay off debts of the business so that the only money owners can lose is the money they invested in the company.

Exceptions to Limited Liability

However, there are some exceptions to this limited liability. An owner of an LLC can lose their protections and be found personally liable if they:

  • Personally guarantee a business debt or bank loan on which the LLC defaults.
  • Co-mingle the LLC's and their personal finances or blur the line between personal and company business.
  • Break the law.
  • Doesn't deposit taxes that are taken out of employees' wages.

The most important factor is owners not acting like the LLC is a separate business. The court can decide that the company doesn't exist and find the members are personally liable for their actions. To prevent this from happening, always act legally and fairly. Don't misrepresent or conceal facts or the state of your finances to creditors or vendors.

Make sure your LLC is adequately funded. Put enough cash in the business so all liabilities and expenses can be met in the future. It's also important to keep personal business and the LLC separate. A federal employer identification number should be obtained, a business-only checking account opened up, and personal finances should be kept in a separate accounting book. Forming an operating agreement is also necessary. Taking these steps will increase your LLC's credibility.

Common Ways LLC Members Can Lose Limited Liability

LLC members may lose their limited personal liability protections under several specific circumstances. These situations typically involve misuse of the LLC structure or failure to treat the entity as separate from personal affairs. Key scenarios include:

  • Failure to Follow Formalities: While LLCs are more flexible than corporations, failing to maintain records, file required documents, or document business decisions can weaken the liability shield.
  • Undercapitalization: If the LLC doesn’t maintain sufficient funds to meet foreseeable liabilities, a court may find the business was never truly separate.
  • Commingling Assets: Using personal accounts for business expenses or vice versa can indicate the LLC is merely an extension of the owner.
  • Fraud or Misrepresentation: If an owner deceives creditors, vendors, or clients while acting on behalf of the LLC, the court may hold them personally liable.
  • Personal Guarantees: Signing a loan, lease, or contract personally (not as a representative of the LLC) exposes members to direct liability.
  • Tortious Conduct: Members may be held personally liable for their own negligent or wrongful actions, even if performed during LLC operations.

These breaches can lead courts to “pierce the corporate veil,” allowing creditors to go after personal assets like homes, vehicles, and savings accounts.

Additional Protection: Business Insurance

Having a solid liability insurance policy will shield personal assets in cases where limited liability protection doesn't. For example, if a massage therapist accidentally hurts a client's back, the therapist's limited liability policy should have them covered. This insurance can also protect against personal assets in case a limited liability status gets ignored by the court.

Insurance will also protect the assets of the LLC from claims and lawsuits. However, the LLC will not be protected if their bills aren't paid. Commercial insurance will not protect corporate or personal assets from business debts that are unpaid, no matter if they're personally guaranteed or not.

Tips to Preserve Limited Liability Status

To reduce the risk of losing limited liability, LLC members should take the following precautions:

  1. Maintain Separate Accounts: Open a distinct business bank account and never mix personal funds with business finances.
  2. Create and Follow an Operating Agreement: This document outlines ownership, management roles, and procedures—key to showing that the LLC is a legitimate business entity.
  3. Keep Accurate Records: Document major decisions, maintain up-to-date financial records, and comply with all local, state, and federal filing requirements.
  4. Avoid Personal Guarantees: Negotiate contracts that do not require members to personally guarantee obligations.
  5. Adequately Fund the Business: Ensure the LLC has enough capital to meet its operating needs and legal obligations.
  6. Obtain Liability Insurance: A commercial general liability or professional liability policy can protect both the business and personal assets in case the LLC shield is breached.

Taking these steps demonstrates that the LLC is a real, independently operated business, which strengthens the legal barrier between members and business liabilities.

Overview of Corporate Limited Liability

If the LLC or corporation can't pay their debts, creditors can only go after the company's assets and not the personal assets of the members. That said, the business owner can be responsible for LLC or corporate debts in several situations.

If a business loan is cosigned, the signers are equally responsible as the LLC or corporation when it comes to paying it back. This is the easiest way to make one liable for the company's debts. If an owner personally guarantees some obligation of the LLC or corporation, the creditor can go after their personal assets if the business ends up defaulting on the loan.

If a company is new or doesn't have many assets, the creditor might require them to provide collateral before they approve the loan. If the house or another personal asset is pledged for the business loan, the creditor can later take that property and sell it to meet the company's obligations. A creditor can also go after personal assets by getting rid of the limited liability protection that the LLC provides.

How Courts Decide to Pierce the Corporate Veil

Courts don’t pierce the LLC veil lightly. They typically evaluate several factors to determine whether the members abused the LLC structure. Common considerations include:

  • Alter Ego Doctrine: If the LLC is essentially the same as its owner, with no real separation, liability may be imposed personally.
  • Injustice or Fraud: The court looks for evidence that limited liability is being used to perpetrate injustice or evade legal obligations.
  • Disregard of Entity Formalities: This includes not holding meetings, failing to keep records, or not filing required documents.
  • Thin Capitalization: If an LLC is formed without sufficient capital to carry out its business purpose, creditors may argue it's a sham entity.

Each case is fact-specific. A court will weigh these factors collectively to determine whether to ignore the LLC structure and impose personal liability on its members.

Frequently Asked Questions

  1. When can members of an LLC lose their limited personal liability status?
    LLC members can lose their limited liability if they commit fraud, mix personal and business funds, undercapitalize the LLC, or sign personal guarantees.
  2. What does “piercing the corporate veil” mean?
    It refers to a legal decision where courts disregard the LLC’s separate legal status and hold members personally responsible for business debts or liabilities.
  3. Can an LLC protect members from personal liability for negligent acts?
    No. LLC members can be held personally liable for their own wrongful or negligent conduct, even if it occurs during business operations.
  4. Is having an operating agreement required to protect liability status?
    While not always legally required, an operating agreement strengthens the LLC's legitimacy and helps uphold limited liability in court.
  5. Does liability insurance prevent personal exposure for LLC members?
    Liability insurance provides an added layer of protection, especially in cases of professional errors or injury claims, but it does not replace the need for proper LLC management.

If you need help with determining the liability of your LLC's members, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.