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Liability limits Featured

5:35am EDT February 18, 2002
The limited liability company, or LLC, is fast approaching the popularity of the corporation. LLCs are doing business in almost as many ways as corporations and can even be publicly traded. Developed more than 20 years ago, the LLC has gained more recent popularity partly due to some key legal changes. Nevertheless, the law surrounding liability limitations for LLC owners is only in its infant stages.

Some courts haven't fully addressed when LLC owners would be liable. Other courts may apply the same rules that exist for corporations. However, the LLC is an entirely different animal -- not quite a partnership, not quite a corporation. Applying corporate principles to limited liability companies is like trying to fit a square peg into a round hole.

Under what circumstances the LLC, as a business entity, protects its owners from losing personal assets in a legal battle is not clear. Such uncertainty should cause some concern among LLC owners. However, LLC owners who conduct business appropriately need not be in fear.

Clearly, in spite of this legal uncertainty, entrepreneurs in Pennsylvania have recognized the value of the LLC and are taking advantage of it. In fact, in 1998, slightly more than 3,600 Pennsylvania LLCs were formed. By 2000, the number of LLCs formed in one year increased to more than 7,300.

LLC owners should take proactive steps to reinforce the "limited liability" of their companies. Structuring your LLC and its business activities properly may help to take some of the uncertainty away. Consider the following:

Corporations - shareholder liability

An individual could be held liable for corporate acts in more than one way. One way is for their actual participation in wrongful activities of the corporation. Another way to hold liable those people owning or running the corporation is to "pierce the corporate veil." That legal jargon is used to describe the situation in which a shareholder is held liable for corporate acts.

This "veil piercing" almost always has to do with either a small or closely held corporation that has failed to properly conduct its business in some way or that has, perhaps inadvertently, become a façade for the activities of one or more shareholders.

Pennsylvania law has created several factors that guide courts in determining whether disregarding the corporate entity is appropriate:

* whether the corporation has failed to comply with required formalities, i.e., meetings, books and records, etc.;

* whether the corporation is undercapitalized;

* whether the affairs of the corporation have been mixed up with the personal affairs of the principals;

* whether the corporation has been used to further personal interests,

* and whether the corporate form has been used to perpetrate a fraud.

Why the corporate rules matter

Why does all this corporate stuff matter if you have an LLC? In spite of its impropriety, courts likely will rely on corporate law when determining whether the owners of an LLC should be held liable. The law as it concerns corporations is well established, and using it prevents judges from having to venture into totally new territory. That's why LLC owners need to know the corporate issues they may have to face.

In general, though, the characteristics of an LLC place it on a continuum somewhere between a corporation and a partnership. LLCs often are taxed and managed like a partnership, but its members are protected from liability like shareholders of a corporation.

Compared to a corporation, the LLC may be structured rather informally and is subject to few of the rigors of procedure that plague corporate existence. On the other hand, the LLC may sell "member interests" almost like shares of stock, and the LLC may operate through managers but be owned by separate members.

LLCs by their very nature are permitted, if not designed, to be formed and operated with relatively little pomp and circumstance. Without being required to set up annual meetings, keep meeting minutes or issue annual reports, LLCs can enjoy relative freedom in operations and management. Corporations, on the other hand, are subject to a number of burdensome formalities. In fact, failure to abide by these formalities is often an important factor causing shareholder liability.

Still, you don't want to take unnecessary chances, given the lack of clarity in the courts about owner liability within LLCs versus corporate law. Therefore, here is a list of some steps you may want to follow to strengthen your LLC's veil:

1. Put your operating agreement in writing (this is a must!)

2. Organize a management team and provide real positions, titles and written business plans.

3. Keep your tax filings current.

4. Set up a bank account (or accounts) for your LLC and avoid (at all costs) using the account for any other person or entity.

5. If you currently have a one-member LLC, add another member.

6. Schedule meetings for the management and the members and take minutes of such meetings.

7. Keep records and generate reports of capitalization, meetings, minutes, ownership interests, dividends, loans to or from the company, business plans, etc.

8. Follow the few required formalities, which will vary slightly from state to state but often include filing a certificate of formation with the secretary of state and paying taxes.

9. Keep your personal activities or the business activities of other companies separate from the LLC. When two or more companies are using overlapping personnel, office space or assets, continue to treat the companies as separate and distinct.

Keep in mind that these points, while helping to prevent personal liability in the event of a lawsuit, will not protect you from being sued. Unfortunately, there are relatively few legal safeguards to prevent a plaintiff from suing both a company and its owners. What matters is how far the lawsuit progresses.

Jeff Aronsohn Jr., is an attorney with Pittsburgh law firm Thorp, Reed & Armstrong, LLP.