A limited liability company (LLC) is supposed to protect your personal assets from the liabilities of your business. That’s why it’s called a limited liability company. But, for various reasons, some have thought that a single-member LLC (SMLLC) does not actually provide asset protection for its owner (member).
This article discusses the issue of whether a SMLLC protects the personal assets of its member.
The short answer is that Colorado courts understand that a primary reason for creating a separate business entity is to obtain liability protection and, accordingly, a SMLLC can protect personal assets from liability. But the longer answer is a bit more complex than that.
Veil Piercing, in General:
The first thing to understand is simply forming a separate limited liability entity – of any kind and with any number of owners or managers – is not by itself enough to guarantee the protection of the personal assets of its owners. A court may lawfully "pierce the veil" of any entity; that is, any entity may be legally ignored or disregarded in the interest of fairness and to prevent wrongdoing.
This is not only true for SMLLCs, but also corporations and other business structures that offer liability protection. A previous entry has already discussed a case where the Colorado Supreme Court pierced the veil of a multi-member LLC that was found to be the "alter ego" of its members – for a general discussion of how veil piercing is analyzed in Colorado, see that entry titled "The State of Veil-Piercing Law (Colorado)."
Simply forming a separate limited liability entity – of any kind and with any number of owners or managers – is not by itself enough to guarantee the protection of the personal assets of its owners.
Last summer, in Sedgwick v. Hinds, the Colorado Court of Appeals took another looking at piercing the veil of an LLC and the case involved a SMLLC.FN1 The depth of analysis makes this case particularly informative on a variety of issues related to veil piercing.
First, the case reaffirms three requirements under Colorado law for piercing the veil of any company. It is only appropriate to disregard a separate business entity when:
The business "entity is the alter ego of the person or entity in issue;"FN2
The interests of justice require recognizing this "alter ego" status, over preserving the fiction of the entity’s separateness; andFN3
Ignoring the existence of the entity and holding its owner(s) liable for the business’s debts and obligations is fairer than the alternative.FN4
As these requirements show, a court will disregard the existence of distinct entity only when its owners or another insider at the company fails, in practice, to treat it as a separate entity.
If you don't treat your business as a separate entity, a court may not either. But it's not enough to simply find that the business was used as the alter ego of its owner(s). The veil will be pierced only when required in the interests of justice and to prevent wrongdoing (which is what the second and third requirements attempt to capture.)
Alter Ego Status, Colorado Factors:
In "The State of Veil-Piercing Law (Colorado)" the factors that determine whether a business is likely to be found to be the "alter ego" of its owner(s) were discussed based on the law at that time. The decision in Sedgwick sheds important light on how a court should interpret some of these factors in the context of a SMLLC.
To determine whether an entity is an alter ego of its owner(s), Colorado courts look at eight (8) factors:
Whether the entity operates as a distinct business entity;
Whether personal and business funds and assets are commingled;
Whether adequate corporate records are maintained;
Whether the nature and form of the entity's ownership and control facilitate misuse by an insider;
Whether the business is thinly capitalized;
Whether the entity is used as a 'mere shell;'
Whether owners disregard legal formalities; and
Whether business funds or assets are used for non-corporate (or personal) purposes.FN5
The decision in Sedgwick sheds important light on how a court should interpret some of these factors in the context of a SMLLC . . . "and not all of the listed factors need to be shown in order to establish alter ego status."
As the Court notes, "This inquiry looks to the specific facts of each case, and not all of the listed factors need to be shown in order to establish alter ego status."FN6
Furthermore, the third and seventh of these factors look at whether the business keeps corporate records and formalities. As discussed below, these factors should not be considered reasons that any LLC is the alter ego of its owner(s). Overall, however, these factors indicate situations where owners are insufficiently respectful, in practice, of the separateness of their business entity.
When an LLC is formed and operates as a separate entity, it should provide asset and liability protection for its owner(s). But substance can dominate form; owners must not only talk the talk, they must also walk the walk. Where a business operates as a distinct entity, its legal fiction will be treated as reality under Colorado law.
SMLLC as its Owner's Alter Ego:
One fact the court found important is that Colorado law “permit[s] the creation of a single-member limited liability company.”FN7 The Court of Appeals seemed to take this as a guiding principle when determining whether a business is the alter ego of its owner(s).
While the Colorado LLC Act requires the application of corporate veil-piercing law to LLCs, it expressly exempts LLCs from the requirement that they observe corporate formalities...
The Court appreciated the fact that if an LLC can lawfully be formed with a single member, the veil piercing law applicable to LLCs cannot make it practically impossible for a SMLLC to achieve the liability protection sought by its formation. This result would not be fair to unsuspecting business owners who relied on the Colorado LLC Act (C.R.S. § 7-80-101, et seq.) and the Colorado Secretary of State in forming a SMLLC for asset or liability protection. They could have saved both time and money if they had known that their entity would have protected them no better than a sole proprietorship.
Additionally, the Colorado LLC Act, while requiring the application of corporate veil-piercing law to LLCs, expressly exempts LLCs from the requirement that they observe corporate formalities, like annual meetings, corporate record or minutes keeping, and electing a board.FN8 As a result, a lack of corporate formalities is allowed by the Colorado LLC Act and, accordingly, cannot be a reason to pierce the veil of an LLC, including a SMLLC.FN9FN10
LLCs - whether single member or not - are often operated with considerably fewer formalities than corporations. Moreover, as creatures of contract, LLCs -- unlike corporations that are creatures of statute -- permit a greater degree of flexibility when it comes to member interaction and the management of the company. In fact, as discussed more fully in the entry titled "Giving 'Maximum Effect' to Operating Agreement Terms" the Colorado LLC Act instructs courts to enforce the terms of an LLC's operating agreement to the maximum extent permitted by law in order to give effect to the agreement of its members.
It would hardly be in keeping with the language of the Colorado LLC Act if courts effectively forced the members of LLCs to adopt and observe the formalities required of corporations in order to avoid piercing the veil of their company. Accordingly, members of any LLC should be permitted to adopt, modify, or forgo corporate formalities as they see fit.
SMLLCs as "Disregarded Entities" for Tax Purposes:
At times, the fact that, by default, a SMLLC is a “disregarded entity” for tax purposes has been taken as a reason supporting veil piercing.FN11 However, an entity's tax treatment - and, specifically, whether it is treated as a disregarded entity – does not affect its separate existence as an entity organized under the Colorado LLC Act.FN12
As a result, the fact that the tax treatment of a SMLLC is like a sole proprietorship is not a factor that supports piercing the veil of that company. This purely a matter of how the entity is treated for tax purposes and not an indication about its separateness or distinctness as an entity under state law.
While a SMLLC can elect to be taxed as a C-corporation (by filing IRS form 8832) or a S-corporation (by filing IRS form 2553), this tax election should not be required in order to avoid a determination that the entity does not exist from the perspective of state law.
Three takeaways from the analysis in Sedgwick are that:
1. An LLC should not have to have more than one member in order to have liability protection.
2. An LLC should not have to observe the formal requirements of corporations in order to have liability protection.
3. An LLC should not have to be taxed as a partnership or corporation in order to have liability protection.
Asset Protection Issues for SMLLCs:
Conversely, the other factors listed above still matter considerably when it comes to whether an entity’s veil will be pierced. For example, the commingling of funds or assets or using business funds for personal expenses are each significant reasons to find that the separateness of a business entity is not adequately respected.
Moreover, SMLLCs face greater difficulties than multi-member LLCs when it comes to the possibility of veil piercing. When a single member is also the manager of the business – either because the entity is structured as a member-managed LLC or because the member is also a manager of a manager-managed LLC – there is a greater risk of misuse of the entity.
In a corporation – where veil-piercing doctrine first developed – the legal basis for providing liability protections for the owners (shareholders) of a corporation was that they are not involved in the decision making of the company or its day-to-day operations. This separation between ownership and management justified limiting the liability of corporate shareholders. As a result of their limited liability, shareholders were potentially liable only to the extent of their contribution to the corporation – i.e., how much money they invested in the company.
When you buy stock, you understand that you might lose all of the money you invested, but you don't think that you might be risking your home, car, or any other personal asset. This is because of the limited liability afforded to shareholders of corporations.
When a single member is also the manager of the business – either because the entity is structured as a member-managed LLC or because the member is also a manager of a manager-managed LLC – there is a greater risk of misuse of the entity.
Shareholders don't participate in – or perhaps even know about – the decisions of the business. Management made those decisions. Whether things blamelessly turn out poorly or there was some wrongdoing, that was not something the shareholders, or owners of the business, were involved in. And they should not be held responsible.
The sole member of a member-managed SMLLC or the managing member of a manager-managed SMLLC cannot as plausibly assert their ignorance about business decisions. After all, their roles and responsibilities include making those business decisions.
SMLLCs should be aware that the potential for overlap between ownership and management increases the risk of veil piercing and steps should be taken, in practice, to eliminate or at least reduce that risk.
For this reason, it is particularly important for SMLLCs to adopt operating agreements and adhere to their procedures and requirements. Operating your business in accordance with a well-drafted operating agreement can provide significant protection to the members’ of your LLC and can help protect them from personal liability.
Furthermore, no LLC can protect you from your own wrongdoing, only that of others. So, in that respect, a SMLLC offers less protection than LLCs with multiple owners. As discussed previously in "The State of Veil-Piercing Law (Colorado)" when an owner is to be held liable for business debts or obligations, the owner must have been involved in the wrongdoing of the business. Otherwise, it is not fair to hold that owner responsible for the liabilities of the business.
In a SMLLC, the chances are significantly greater that the sole member was responsible for the wrongdoing. As a result, arguments against personal liability often carry less weight in the context of a SMLLC.
Additionally, the sole member of a SMLLC is more likely to blend their personal and business finances and make company decisions in ways not authorized by the business’s operating agreement or the Colorado LLC Act. For this reason, it is important for even SMLLCs to have operating agreements that detail the procedures and processes for decision making and to conduct the business of the company in accordance these procedures and processes in its day-to-day operations.
While an LLC need not observe corporate formalities, some formalities still must be respected, including having separate bank accounts for the business, documenting money in and out of the company, and following the procedures and processes laid out in the company’s operating agreement.
The bankruptcy of the sole member of a SMLLC is another context where a SMLLC may provide less asset protection than that provided by LLCs with more than one member. By filing for bankruptcy the sole member’s entire interest in the SMLLC is transferred to the bankruptcy estate and, generally, when a transferee receives all of the interest in an LLC they are allowed to designate a new member. This effectively gives the bankruptcy estate control over the SMLLC, even if it is manager-managed since the newly designated member likely has the ability to replace any current manager with another of their choosing.
Remaining Uncertainty after Sedgwick:
While the Sedgwick decision provides important guidance for owners of SMLLCs, some questions remain. First, in Sedgwick the Court was considering piercing the veil of a manager-managed LLC, not a member-managed LLC. A manager-managed LLC necessarily separates the roles related to management and those related to the ownership of the company.
As discussed above, the separation between ownership and management in corporations is, and historically has been, an important justification for limiting shareholder liability. A manager-managed LLC is also structured with this separation. It is currently unclear whether this could be an important factor in future veil-piercing cases in Colorado.
A previous article looking at the management structure of LLCs noted that it is generally preferable to form an LLC in Colorado as a manager-managed LLC. That article was primarily concerned with agency relationships created when forming an LLC, and is not just because of a greater possible resistance to veil piercing. But this resistance is an additional reason to form a manager-managed LLC.
Perhaps even more importantly in terms of remaining uncertainty in the law after Sedgwick is that the case not only involved a manager-managed SMLLC, but it was the manager - not the owner - of that SMLLC that was potentially liable for business obligations. Veil piercing doctrine is potentially applicable to others involved in a business, and not simply owners. But those are the rarer circumstance and generally veil piercing doctrine is applied to a person with at least some ownership interest in the company.FN13
Moreover, the manager of the SMLCC in Sedgwick was a management company that managed several different businesses, and not just the SMLLC involved in the case. That the management company managed other businesses limits the possibility that the company was a "mere shell" or the alter ego of the SMLLC. As a result, veil piercing would be inappropriate for this reason alone.
Sedgwick does not answer all of the questions whose answers would be helpful for potential owners or operators of SMLLCs. There may yet be circumstances where SMLLCs do not provide all of the asset protection that they should. But, by making good choices and respecting your business as a distinct entity, SMLLCs can still provide the liability protection from which they get their name.
If you would like assistance forming an LLC or drafting an operating agreement or Articles of Organization - or if you would like to find out whether your operating agreement is tailored to the needs of your business - please Reach out, Today!