“THE STINKING LLC REPORT”
Hello, my name is XXXXXX, and I am a California attorney that has been practicing since 1976. I have always been in sole practice. Most of my clientele is made up of the so called “little guys” and “gals.”
Not infrequently, I get inquires from clients about whether they should incorporate whether “C” or “S” (formerly Sub-S) or form an LLC for either their personal or investment holdings. I also get questions about trusts, typically grantor trusts [one’s that are revocable vis a vis irrevocable] and inter vivos [created and effective while alive, you don’t have to die first].
I never cease to be amazed by the extraordinary claims [tax, limited liability, asset
protection, et cetera] many of these clients are absolutely convinced these legal entities possess. Furthermore, many have heard so many times that these legal entities eliminate all manner of taxes, protect all manner of assets from lawsuits and insulate them from all manner of personal liability that it is treated as if such claims are indisputable laws of the universe. End of discussion! Well this attorney for the “little guy and gal” is here to tell you, “The emperor has no clothes!” Well, maybe some boxers or Haines ..... but not much else, for the little guy or gal.
Lets talk LLC and limited liability for its members [owners]. Lets see what The Rutter Group, a highly regarded source of California law [Legal Treatise] of which many of its authors are either law school professors or retired appellate judges, has to say.
1. An LLC like a Corporation Is a Separate Legal Entity from Its Members/Shareholders.
Yes, an LLC is recognized as a legal entity separate and apart from its “members” (i.e.,its owners) and both corporations an LLC can be made up of only one shareholder or member. [Calif. Corp Code Sections § 17050(b), 17003, and 17101].
So far so good!
2 The Personal Liability of an LLC Member Is the Same as a Corporate Shareholder.
The Rutter Group, 2004, Cal. Prac. Guide Section d.[2:36.3] goes on to explain the liability of an LLC member is the same as a Corporate Shareholder:
Limited liability of members: Ordinarily, only the LLC can be held responsible for the entity's debts. Subject to narrow exceptions, the LLC members are not personally liable for the entity's obligations and/or liabilities and thus enjoy the same "limited liability" as corporate shareholders [Ca Corp § 17101(a); See PacLink Communications Int'l, Inc. v. Sup.Ct. (Yeung), , (2001) 90 Cal.App.4th 958, 963.]
Still sounds good to the client and to the purveyors of LLC products. But what’s this little comment about “narrow exceptions”?
3. “Traditional Exceptions” ... Guarantor Liability and Alter Ego Liability
First, if an LLC member personally guarantees any debt or obligation of the LLC, the
member is generally personally liable for it. [Calif. Corp Code Sections §7101(b)].
Practical effect: If you’re a member of an LLC with few members or even worse a one person LLC, most lenders and even many suppliers are going to require the members to guarantee the debt, contract or other obligation of the LLC.
Uh, oh! One crack in the invisible LLC/Corporate protection for the little guy!
Second, common law “alter ego” liability has been specifically retained, in California, at least. Calif. Corp Code Sections §7101(b) provides that an LLC member may be liable for an LLC's obligations under the common law “alter ego doctrine.” However under certain conditions failing to observe LLC formalities shall not be a factor establishing alter ego liability.
Traditionally, one of the factors considered where a court imposed personal liability on under the alter ego liability doctrine involved cases where shareholder meetings, board of director meetings, stock certificate issuance, corporate resolutions et cetera had been ignored. If you didn’t act like a corporation, you didn’t get the protection of a corporation. The old maxim, gotta quack like a duck to be considered a duck.
But note, there are other factors a court will consider in whether or not to apply the alter ego doctrine. One “biggie” is under capitalization. If your favorite [dare I say “pet”] LLC is not capitalized sufficiently to pay its debts, a court may impose personal liability to prevent “injustice.”
Solution: Leave or put in “lots/adequate” cash in the LLC to limit/prevent alter ego liability. But if little guy/gal does that the money is tied up in the LLC and the creditor debtor collector doesn’t care about personal liability because it can be soooo easily levied upon with a judgment against the LLC only. Drat! I don’t want to leave my cash tied up in the LLC. Well then, run the risk of personal liability under the alter ego doctrine. Huh, crack number two?
Sound a little like a “catch 22"? Leave in the $$$, creditors don’t need to go after you personally. Take out the $$$, you may be personally liable for under capitalization. The $$$ is gone either way.
4. Tort Liability of LLC Members [The Big Kahuna of the Stinkers?]
As if crack one and two weren’t enough, LLC members and shareholders have personal liability when acting on behalf of their LLC or Corporation, if their actions involve a tort. As The Rutter Group, 2004, Cal. Prac. Guide Section d.[2:36.3] explains:
Apart from potential liability under the alter ego doctrine, and even when alter ego liability is not warranted, shareholders are personally liable if they directly ordered, authorized or participated in a corporation's tortious conduct. In such circumstances, the shareholders' liability does not arise from their positions as shareholders, but from their own affirmative misconduct. [Filet Menu, Inc. v. C.C.L. & G., Inc. (2000) 79 Cal.App.4th 852, 866; see Wyatt v. Union Mortgage Co. (1979) 24 Cal.3d 773, 785] Indeed, where shareholders are found directly liable, alter ego liability is superfluous. [Filet Menu, Inc. v. C.C.L. & G., Inc., supra]
Okay, now for the English transaction for lay persons. Tortious conduct means wrongful. However, under tort law wrongful is not limited to intentionally harming someone. It includes negligence. Now I am sure, even the “lay-est” of lay persons have heard of negligence and of people being sued for being negligent. Crack! The LLC, Titanic, has now hit the iceberg! Why? Because for the smaller the number of members in an LLC or shareholders in a Corporation the harder it is going to be to successfully prove that member/shareholder being sued along with the LLC/Corporation did not directly ordered, authorized or participated in the LLC’s or Corporation's tortious conduct.
Example 1. Little Guy/Gal have a rental unit(s). The units are put in an LLC. Little Guy/Gal do some electrical repair. Tenant is shocked. Electric repair done negligently. Who directly ordered, authorized or participated in the LL C’s or Corporation's tortious conduct i.e. the negligent electrical work? You got it, Little Guy/Gal.
Example 2. Little Guy/Gal have a rental unit(s). The units are put in an LLC. Little Guy/Gal hire a cost saving unlicensed electrician to do some electrical repair. Tenant is shocked. Electric repair done negligently. Who directly ordered, authorized or participated in the LLC’s or Corporation's tortious conduct i.e. the negligent hiring of an unlicensed electrician work? You got it, Little Guy/Gal.
Example 3. Little Guy/Gal have a rental unit(s). The units are put in an LLC. Little Guy/Gal hire an on site manager to maintain the premises including sweeping the walkways. A banana peel is left for hours [days?] on one of the walkways. Tenant slips and falls. Injuring himself/herself, naturally. Negligent maintenance of the common areas. Who directly ordered, authorized or participated in the LLC’s or Corporation's tortious conduct i.e. the negligent failure supervise the on site manager and make sure the common areas are properly maintained? You got it, Little Guy/Gal.
Example 4. Little Guy/Gal have a rental unit(s). The units are put in an LLC. Little Guy/Gal decide not to rent to certain persons because of race, color, creed, national origin, sexual orientation, marital status or number of children etc. Potential Tenant is refused accommodations and sues. Who directly ordered, authorized or participated in the LLC’s or Corporation's tortious conduct i.e. the promulgation or implementation of unlawful discriminatory renting practices? You got it, Little Guy/Gal.
Example 5. Little Guy/Gal have a rental unit(s). The units are put in an LLC. Little Guy/Gal hire a property management company which decides not to rent to certain persons because of race, color, creed, national origin, sexual orientation, marital status or number of children etc. Potential Tenant is refused accommodations and sues. Who directly ordered, authorized or participated in the LLC’s or Corporation's tortious conduct i.e. the hiring of a property management company which promulgates or implements unlawful discriminatory renting practices? You got it, Little Guy/Gal. Well, maybe on this one. But do you really want to litigate whether or not you, i.e. Little Guy/Gal are sufficiently removed from the ordering, authorizing or participating in the LLC’s or Corporation's tortious conduct?
For these and other reasons I agree with the comment made by the Rutter Group:
While avoidance of personal liability for business debts is a distinct
advantage of the corporate form, the advantage is more theoretic than real. As
shown above, the advantage is usually restricted to uninsured tort claims, and
claims by creditors who were willing to rely on the corporation's credit without
shareholder guarantees. And, even in such cases, personal liability can still be
fastened on the shareholders if there are grounds for "piercing" the corporate
veil or if the shareholders directly authorized or participated in corporate
wrongdoing. Therefore, avoiding personal liability for business debts or
liabilities is frequently not a determinative factor in deciding whether to
incorporate a new or small business venture.
The case of Wyatt v. Union Mortgage Co. (1979) 24 Cal.3d 773, 785 held the following:
Directors and officers of a corporation are not rendered personally liable
for its torts merely because of their official positions, but may become liable if
they directly ordered, authorized or participated in the tortious conduct. (United
States Liab. Ins. Co. v. Haidinger-Hayes, Inc. (1970) 1 Cal.3d 586, 595.) Personal
liability, if otherwise justified, may rest upon a "conspiracy" among the officers
and directors to injure third parties through the corporation. (Golden v.
Anderson (1967) 256 Cal.App.2d 714, 719-720; cf. Gruenberg v. Aetna Ins. Co.
(1973) 9 Cal.3d 566, 576]; Wise v. Southern Pacific Co. (1963) 223 Cal.App.2d
50, 72.) Shareholders of a corporation are not normally liable for its torts, but
personal liability may attach to them through application of the "alter ego"
doctrine (see, e.g., Associated Vendors Inc. v. Oakland Meat Co. (1962) 210
Cal.App.2d 825, 836-837), or when the shareholder specifically directed or
authorized the wrongful acts.
When judged against these legal standards, the record supports the ...
verdict. First, evidence was introduced at trial to show it was company policy to
lure potential borrowers ... through misleading "bait and switch" advertising.
Secondly, on several occasions, appellant Tushner instructed other company
officials that ....
The record further discloses a tightly knit, family-oriented business
operation under appellant Tushner's close personal control. Tushner owned all or
a controlling interest in each of the affiliated corporations. Each of the other
individual [defendants] was an officer or director of one or more of the
corporations and each was active in some management position at some time
during the years when the conspiracy is alleged to have occurred.
Let me ask you, how can a one person LLC or few person [“tightly knit”] LLC do much of anything without the members directing or authorizing the wrongful acts? I advise all my clients to consider these “unheard of” [ignored?] limitations before incurring the expense of forming and maintaining an LLC. Often rather than spending the money to form an LLC, maintain keep separate books and records, pay state income tax [gross receipts], file various the various forms and returns with the state or federal government, the money is better spent on getting insurance with as broad a coverage and as high a policy limit as possible/affordable.
By the way, one cannot obtain insurance coverage against an intentional tort/wrongdoing; however, virtually all lawsuits alleging intentional torts are combined with claims of negligent torts. Why is that important? Because in addition to a duty to pay any negligent claim, an insurance company has the broader duty to defend both the intentional claim and the negligent claim when they are both part of the same lawsuit. In other words, in most cases the insurance company must provide you with a lawyer to defend both the intentional claims as well as the negligent ones at no additional cost. In the final analysis, aren’t you trying to limit personal liability because of the money a personal judgment will cost you? Well, if you, along with your LLC are sued, you will still have to pay your defense counsel. And, you can bet defense counsel
will want your personal guarantee on any fee agreement unless your LLC is a “cash cow.” However, with insurance, the costs of defense counsel are generally covered unless the claim is strictly for intentional wrongdoing or the claim is not a covered item.
For those of you not doing business in California, before you “86" this Stinking LLC
Report, please note: all states derive their law from the “English Common Law” [my good Cajun friends from Louisiana excepted (Code Napoleon)], therefore, these or similar principles very well may apply. Of course, confer with local tax and legal professionals before making your decision to form an LLC or forego it.
Best Regards,
Attorney at Law.
