The liability protection afforded by corporations and LLCs can be likened to that of an insurance policy. While insurance policies provide important protection, they are subject to various limitations and exclusions. The following are some of the more important limitations and exclusions that are applicable to corporations and LLCs:

• Piercing the LLC veil. The terms “Piercing the veil” or “alter ego liability” are regularly used to describe a judicially created principle which allows a creditor to pursue the individual owners of an entity such as a corporation or LLC. Courts will permit a creditor to pursue a claim against individual owners if certain factors are present, and piercing is necessary to avoid an injustice. Piercing can be justified if some of the following factors exist: inadequate capitalization, commingling of funds, and failure to observe proper formalities.The California Limited Liability Act specifically provides that the “piercing” doctrine, which was originally developed in the context of corporations, is applicable to LLCs, with one important exception. LLCs can be operated on a more informal basis, like a partnership. Accordingly, the LLC Act provides that failure to hold meetings and the failure to observe formalities pertaining to the calling or conduct of meetings cannot be used against an LLC unless the articles or operating agreement expressly require the holding of meetings.
• Personal participation in tortious conduct. It is important to note that, a member-employee will always remain personally liable for damages caused by his or her own negligence and intentional acts of misconduct, regardless of the existence of the LLC.A person is always liable for his own wrongful acts, whether intentional or accidental. Accordingly, an owner of an LLC will always remain personally liable for damages caused by his or her own negligence and intentional acts of misconduct, regardless of the existence of the entity. For example, an owner of small LLC gets into a car accident on the way to work. The LLC would not protect such a person from personal liability arising from their negligence.
• Failure to pay payroll taxes. Businesses hard pressed to make payroll or facing a financial crisis invariably fail to pay to the IRS the employees’ portion of taxes withheld. It is important to note that the person who is responsible for the payment of taxes withheld from employee pay and for payment of the the employee share of payroll taxes holds those funds in trust for the federal government. The IRS will hold you personally responsible for this failure, even if you are operating as an LLC or corporation.
• Personal guaranties. Of course, if an owner of a corporation or LLC executes a personal guaranty of a bank loan or lease, or some other contract, he or she will be personally liable for the debt. For example, a married couple operates an LLC. In order to help with finances, the owners ask a local bank for a loan. The bank agrees to provide the loan, but only if the couple personally pledges the equity in their house as security for the loan. If the owners agree to this, and the LLC business fails and is unable to pay off the loan, the bank would have the authority to go after the owners individually, or even foreclose on the house.

Many clients interested in forming a business entity, such as an LLC, are under the mistaken impression that an LLC completely shields them from any and all liability. While a properly formed LLC does offer liability protection, its protection is limited in scope. Moreover, it is important to understand that a properly formed LLC must be properly maintained in order to assure limited liability protection in the future.

The personal liability of a LLC owner is generally limited to the amount they have invested in the LLC. However, under certain circumstances, limited liability can be set aside by the courts. The basis for setting aside such protection is known as the alter ego doctrine.

Under the doctrine of alter ego, the courts may disregard the concept that the separate existence of an LLC is distinct from that of its owners, and “pierce the LLC veil” thereby exposing the owners to personal liability for LLC debt. The alter ego doctrine, which originally arose in the context of corporations, provides that the corporate veil may be pierced when:

• There is such a unity of interest between the shareholders and the corporation that the separate personalities of the corporation and the shareholders do not in reality exist; and
• Recognition of the shareholders and the corporation as separate entities would be inequitable.

The California Supreme Court has noted that “[t]here is no litmus test to determine when the corporate veil will be pierced; rather the result will depend on the circumstances of each particular case.” Accordingly, numerous factors may be considered in evaluating each prong of the alter ego doctrine.

The California Limited Liability Act specifically provides that the “piercing” doctrine developed in the context of corporations is applicable to LLCs, with one important exception. LLCs can be operated on a more informal basis, like a partnership. Accordingly, the LLC Act provides that failure to hold meetings and the failure to observe formalities pertaining to the calling or conduct of meetings cannot be used against an LLC unless the articles or operating agreement expressly require the holding of meetings.

Accordingly, the following are some of the important factors to consider when forming and operating a California LLC: An LLC must be adequately capitalized. Initial funding of an LLC is often difficult, and many clients try to fund an LLC with a bare minimum of assets. Unfortunately, under funding (also called “undercapitalization”) is commonly found in alter ego cases. There is no case, statute, or regulation which defines the amount of capital that is required to avoid personal liability. The cases where the courts found the capitalization inadequate are so extreme that they are not helpful in clarifying an adequate level of capital. Consequently, it is best to be conservative and invest more money in exchange for ownership interest rather than less. The amount must be based on the financial needs of the business.

Personal funds and assets must not be commingled with corporate funds and assets. It is essential that LLC owners keep their personal business activities and finances completely separate from that of the LLC. For example, owners should never commingle personal funds or other assets with those of the corporation. The LLC must have its own separate bank account.

LLC formalities must be observed. it is important to:

• Obtain a tax identification number for a new business entity;
• File a separate income tax return when necessary;
• Make sure that LLC owners sign documents in the name of the LLC;
• Keep detailed financial records; and
• Comply with all annual filing requirements set forth by the state.

An LLC allows greater flexibility in structuring management and control than any other business form. An LLC can be managed in one of two ways: Member-Managed or Manager-Managed.

In a Member-Managed LLC (the form most frequently used by small businesses), the LLC is managed like a partnership or sole proprietorship with each Member partaking in the day-to-day activities of the LLC. Members may be designated as President, Vice-President, Treasurer, etc., but this is not required; many times they simply refer to themselves as “Managing Member” or simply “Member”.

In a Manager-Managed LLC, the company designates a Manager or Managers (who may or may not be Members) to run the day-to-day activities of the company. The other Members are passive and not involved in the daily operation of the company, they simply provide money or assets for the managers to operate the company. This is fairly rare for small businesses.

Yes. In most states, LLCs are required to file annual or biennial statements setting forth LLC members/managers, physical address and resident agent.

Ordinarily, members have voting rights which directly correspond to their percentage interest in profits (and losses), unless the operating agreement provides otherwise.

All legal documents should be executed by an officer of the company in their official capacity on behalf of the company. Here is an example:

Yes. The distinction between the LLC and its owners must always be observed. Accordingly a separate bank account should be opened so that LLC funds are not commingled with personal funds. Even if you already have a separate bank account for your business as a sole proprietor, it is best to open a new bank account for your LLC since the federal tax identification number for the bank account will be different once your LLC is formed.

Simply contact your desired bank and inquire about opening a business account. A taxpayer identification number and a copy of the LLC Articles of Organization will likely be required. For further information you should contact your bank.

No. Unlike a sole proprietorship or a partnership, an LLC is a legal entity separate from its members. The members enjoy limited liability for the LLCs legal obligations and debts as long as this separateness is preserved. If personal funds are commingled with LLC funds so that they become indistinguishable, or if LLC funds are used for personal expenses, a court may hold the members personally liable for LLC obligations and debts.