INCORPORATION OR LLC?

IVAN HOFFMAN, B.A., J.D.



        If you are contemplating incorporating or setting up a limited liability company (LLC) to operate your business, there are some significant legal issues you must resolve.  Please note that these decisions are integrally tied in with accounting and tax issues as well and thus it is important that your attorney and you have continuing discussions with your certified public accountant about the implications of both the initial and subsequent decisions.  Please note as well that while this article deals with general legal issues applicable to corporations and LLCs throughout the country and specifically to the law of California, the actual formation of the entity is generally governed by state law and thus you should consult an attorney and certified public accountant in your state.

Similarities and Differences

        There is a notion, often held by non-attorneys, that merely establishing either an LLC or a corporation confers an insulation from personal liability as to creditors.  This is not true for either entity.

        In both an LLC and a corporation, the individual members or shareholders can, under certain circumstances, shield themselves from personal liability to creditors and limit their liability to their membership or shareholder investment in the LLC or the corporation.  However there are limits to this “shield” and if the “shield” is not upheld, creditors can file lawsuits against the shareholders and members seeking to hold these shareholders and members liable for what might otherwise be debts and obligations of the corporation or LLC.

        California Corporations Code, section 17101 provides in part, as to an LLC:

(a) Except as otherwise provided in Section 17254 or in subdivision (e), no member of a limited liability company shall be personally liable under any judgment of a court, or in any other manner, for any debt, obligation, or liability of the limited liability company, whether that liability or obligation arises in contract, tort, or otherwise, solely by reason of being a member of the limited liability company.

(b) A member of a limited liability company shall be subject to liability under the common law governing alter ego liability, and shall also be personally liable under a judgment of a court or for any debt, obligation, or liability of the limited liability company, whether that liability or obligation arises in contract, tort, or otherwise, under the same or similar circumstances and to the same extent as a shareholder of a corporation may be personally liable for any debt, obligation, or liability of the corporation; except that the failure to hold meetings of members or managers or the failure to observe formalities pertaining to the calling or conduct of meetings shall not be considered a factor tending to establish that a member or the members have alter ego or personal liability for any debt, obligation, or liability of the limited liability company where the articles of organization or operating agreement do not expressly require the holding of meetings of members or managers.

        Section (a) provides the possible “shield” only against the mere allegation or proof that a person was a member and nothing more.  The more pertinent and often overlooked provision is section (b) which says that a member of an LLC can be liable to the same extent as a shareholder of a corporation under the law of “alter ego.”   To try to avoid this “alter ego” or “piercing the corporate [or LLC] veil,” the LLC or corporation must be treated as a completely separate entity from its members or shareholders.  The entity must not be treated as merely an extension of the member or shareholder.  There are many aspects to how this separateness should be approached and you should consult with your attorney and certified public accountant about the same.  Failure to observe this separateness, whether of an LLC or a corporation, can result in the personal liability of the member or shareholder.  Additionally there are other factors that can go into the piercing the corporate (or LLC) veil and holding the shareholders or members liable including but not limited to inadequate capitalization and other factors.

More On Formalities

        But there is another wrinkle that is one of the differences between LLCs and corporations and that has to do with observing other “formalities” of the operation of the particular entity.

        One of the factors that creditors point to in seeking to hold shareholders or members liable for corporate or LLC obligations is that the formalities of the entity were not observed.  In the corporate setting, this means that both regular and annual meetings were not held or that appropriate waivers of notices were not signed and filed or other failures to observe formalities.  As section (b) above indicates, one of the exceptions to the liability issue in the LLC context is that the failure to observe those formalities which are indicated in the said section cannot be used by creditors as proof of the alter ego liability provided that the articles of organization or the operating agreement do not expressly require the holding of such meetings.  Thus, when you form your entity and prepare these documents, you must be very careful if you are using “boilerplate forms”or corporate services without the benefit of an attorney with experience in these areas of the law.

        Additionally, the California statute above states in subsection (c) that a member of an LLC can be liable if the member has expressly agreed to be so liable under a written guarantee and if the member or shareholder has participated in what the law refers to as “tortious conduct.”

Conclusion

        There are other bases for liability of members or shareholders but I have wanted to focus on these threshold issues that are often misunderstood.  And again, the question of whether to choose either of these entities as a manner of doing business is also a function of tax and accounting issues that should be resolved among the client, the attorney and the certified public accountant.

        The moral here is that the unaware can find themselves facing lawsuits against them personally and their assets, beyond their interest in the LLC or corporation.  Setting up an LLC or a corporation requires legal knowledge regarding the actual formation and then operation of the entity.  Using self-service, copy and paste corporate or LLC kits or software may lead to unintended and potentially disastrous results.

        This is not a do-it-yourself project.

© 2001 Ivan Hoffman.  All Rights Reserved.

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This article is not legal advice and is not intended as legal advice.  This article is intended to provide only general, non-specific legal information.  This article is not intended to cover all the issues related to the topic discussed.  The specific facts that apply to your matter may make the outcome different than would be anticipated by you.  This article is based on United States law.  You should consult with an attorney familiar with the issues and the laws of your country.  This article does not create any attorney client relationship.

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No portion of this article may be copied, retransmitted, reposted, duplicated or otherwise used without the express written approval of the author.

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