Can I Sue the Owner of an LLC?
Yes, in certain instances. Although the general rule is that the owners, or members, of an LLC are not personally liable for the debts of the business, they may be found liable in at least two situations: when they personally guaranty the debt, and, in very limited circumstances, when a court decides to “pierce the corporate veil" and hold them personally liable.
What Is an LLC?
An LLC, or limited liability company, is a business structure created by state law. The owners are called members. Most states do not restrict ownership, so members can be people, corporations, or other LLCs. Although a few types of businesses, such as banks and insurance companies, cannot operate as LLCs, you can otherwise do virtually any type of legal business in that form.
How Do You Form an LLC?
Specific requirements vary from state to state, but forming an LLC is simple. First, you choose the LLC's name. Then you file articles of organization, which establish the rights, powers, liabilities, and other obligations of the LLC's members. Next, you provide certain business information, including the business's address, the name and address of the LLC's registered agent, and the names and addresses of the members of the LLC. Pay the filing fee, and don't forget to get an Employer Identification Number (EIN) from the IRS. With that, you're done. You typically can do this online; you don't need a law firm.
Why Is an LLC Beneficial?
There are several reasons why business owners choose to do business as an LLC, particularly single-member LLCs. The primary reason is asset protection. The law recognizes an LLC as a separate legal entity in its own right. This acts as a liability shield for individual members. Generally, the members of an LLC are not responsible for the debts of the LLC and enjoy personal liability protection if the LLC fails. And that means that if the business folds, your personal assets are not at risk (so your house is safe).
Another reason is that doing business as an LLC provides for more flexibility, particularly to entrepreneurs, small businesses, and sole proprietorships, with fewer administrative inconveniences than other legal entities. For example, an LLC does not have to observe all the formalities that a corporation does, such as install a board of directors or hold shareholder meetings.
A third reason is the tax benefit. Other business entities, such as corporations, face “double taxation." That's where a corporation pays tax on its income, and then the shareholders pay income tax on any dividends. So money paid to the shareholders is taxed twice. On the other hand, for an LLC there can be “pass through" taxation. This allows your share of the profits to be taxed just once on your own tax return. More money in your pocket.
A fourth reason is that an LLC enjoys great flexibility in determining how profits and losses are shared by the members. LLCs with more than one member typically have an operating agreement. In that operating agreement, the members can set out how they want to divide the profits and losses. For example, you may have a two-member LLC in which one member puts up most of the money, but the other member spends most of their time doing the work of the business. That operating agreement could take each member's contributions into account in a manner they decide and not just as a 50-50 split.
When Can I Sue an LLC?
Suppose you make phenomenal donuts. You feel a moral obligation to make them available to the world. You make a contract with a donut shop, a limited liability company with one member, to sell them. You're up all night, kneading feverishly, and bring your donuts to the shop in the morning. After your delivery, you dust the flour off your hands, take a shower, and go to bed. Job well done.
Later that day, you call the shop and ask how the donuts sold. Like gangbusters, you are told. You say great, and only then remember to ask – when are they paying you? They tell you that the “check is in the mail." Great.
Of course, the check never arrives. You need that money, so you sue the shop and get a judgment. You try to collect on it, only to find that the shop has closed and has no money to pay it. Where's the member of the LLC? On a yacht off the shores of Tahiti.
Although the general rule is that the members of an LLC are not personally liable for its debts – after all, that is the primary reason businesses operate as LLCs in the first place – there are two exceptions to this general rule. So you might have a chance to recover.
When the Members Personally Guaranty the LLC's debts
The first involves personal guaranties. A guaranty is an agreement to be responsible for someone else's debt. It's essentially a contract. If the person you guaranteed fails to pay a debt, then you can be sued for breach of contract. When doing business with an LLC, many people and companies insist that the member or members of the LLC agree to be personally responsible just in case the LLC goes belly up.
But you didn't get a personal guaranty. That does not mean you're doomed. Although it's a steep uphill battle (and states' laws vary dramatically), you may be able to persuade a court to “pierce the corporate veil" and hold the member responsible for the money the LLC owes you.
When the Circumstances Support Piercing the Corporate Veil
The phrase “piercing the corporate veil" refers to a situation in which a court decides to disregard the fact that the LLC is a legal entity separate from its members. It essentially throws out the liability protection an LLC provides, which results in the imposition of personal liability on the LLC's members.
Courts do not do this as a matter of course. Far from it — it's rare. And if you raise this issue, you will have a battle on your hands — this is the most litigated issue in business law.
Why Might a Court Pierce the Corporate Veil?
So why might a court pierce the corporate veil? The main reason is fraud. If a court believes that a member of an LLC, by word or deed, led you to believe that they personally would be on the hook for a debt, it might decide to pierce the veil and hold the member personally liable.
Another reason is fundamental fairness. To most people, it just feels wrong for you to be out the money for the donuts while the person who benefitted from your hard work tans on a yacht. If a court thinks it is fundamentally unfair for you to have to bear a loss in a particular situation, it may consider holding the LLC member liable.
What Does a Court Look at When Piercing the Corporate Veil?
The decision to pierce the corporate veil is fact-specific, and the relevant factors vary profoundly from state to state. But generally speaking, courts look at the following things:
- Whether there is a real separation between the LLC and its members (otherwise, the court might find the LLC is a “sham" or the “alter-ego" of its members)
- Whether the members operated the business as if it weren't an LLC (for example, they paid business debts from personal accounts, didn't record business decisions, failed to tell third parties that the business was an LLC, etc.)
- Whether the members failed to follow “corporate formalities" (failed to keep accurate corporate and financial records, follow the member agreement or the articles of organization, etc.)
- Whether the members adequately capitalized the business (in other words, whether, the business was funded enough to pay debts and taxes at the time it was formed, recognizing that businesses sometimes in the ordinary course lose money)
Consult an Experienced Business Attorney
Recovering money from a defunct LLC is not easy. If you have the personal guaranty of its members, great. But if you do not, and you cannot otherwise collect on a judgment after exhausting all other means, you may be able to persuade a court to pierce the corporate veil and hold the LLC's members personally liable.
As you can see, this can get extraordinarily complicated. If you find yourself in the position of having to sue an LLC, you should consider consulting with an experienced business lawyer to help guide you through the legal process.