Maintaining the Corporate Veil and Avoiding Personal Liability
Often owners of real estate park their holdings, especially commercial and investment real estate, in limited liability companies. LLC’s are pass-through entities that are not separately taxed. Interest and depreciation deductions pass through to the owners and the owners don’t have to be natural persons or have the limited characteristics of owners of Subchapter S corporations.
But one of the main reasons people form LLCs is to avoid personal liability for contracts and contractual debts related to their business. Generally, pursuant to A.R.S. § 29-3304, members, managers and employees of a limited liability company cannot be sued for the contracts of the limited liability company. Arizona recognizes that a limited liability company, like a corporation, is a legal entity that exists separate and distinct from its members; the members and employees are not liable for the corporation’s contractual obligations or the actions those individuals take on behalf of the corporation. See Kirchof v. Friedman, 10 Ariz.App. 220, 222, 457 P.2d 760 (1969); Ferrarell v. Robinson, 11 Ariz.App. 473, 465 P.2d 610 (App. 1970) (a corporation is a legal entity doing business on its own credit as distinct from the credit of its shareholders, and an individual defendant, either as an officer or director, cannot be held liable on the corporate contracts where there is no evidence that he undertook to bind himself individually on those contracts).
But, sometimes, creditors’ attorneys look to “pierce the corporate veil” using a concept first developed with respect to corporations that the courts have more recently applied to LLC’s. Using that concept those attorneys in breach of contract cases attempt to hold the owners liable on a company debt. “The principle of piercing a corporate veil applies to claims for which one seeks to reach the personal assets of a corporation’s directors or shareholders.” Hall v. Smith, 214 Ariz. 309, 316, 152 P.3d 1192, 1199 (Ct. App. Div. 2007), citing Leo Eisenberg & Co., Inc. v. Payson, 162 Ariz. 529, 534, 785 P.2d 49, 54 (1989). In order for the corporate form to be ignored, the corporation must be considered the alter ego of the individual from whom recovery is sought and recognition of the corporate form would sanction a fraud or promote injustice. Employer’s Liability Assur. Corp. v. Lunt, 82 Ariz. 320, 313 P.2d 393 (1957); Honeywell, Inc. v. Arnold Const. Co., Inc., 134 Ariz. 153, 654 P.2d 301 (App. Div. 1, 1982), and Youngren v. Rezzonico, 25 Ariz.App. 304, 543 P.2d 142 (Ct. App. 1975). “A corporate entity may be disregarded when necessary to do justice.” Gonzalez & Co., Brokers v. Thomas, 42 Ariz. 308, 312, 25 P.2d 552, 554 (1933), citing Phoenix Safety Investment Co. v. James, 28 Ariz. 514, 237 P. 958, 959 (1925); Mosher v. Lee, 32 Ariz. 560, 261 P. 35 (1927); Mosher v. Salt River Valley Water Users’ Ass’n, 39 Ariz. 567, 8 P.2d 1077 (1932).
A piercing the corporate veil argument can be avoided or the risk reduced by following some simple steps to maintain the limited-liability advantage that gives LLC’s their name. One should make sure to keep the LLC’s and statutory agent’s address updated with the Arizona Corporation Commission anytime either of those addresses change. Not doing so could allow the Arizona Corporation Commission to administratively dissolve the LLC leaving consequent exposure for those who relied on the shield of the entity
Also, one should have a signed Operating Agreement for the LLC. The Operating Agreement needs to be executed to be effective. Another reason to have a signed operating agreement is that lenders often will require one before they will make a loan to an LLC.
One of the main arguments some creditor attorneys use to pierce the corporate veil is to argue that the LLC is just the alter ego of the owners/members. This happens mainly when the owners/members of the LLC are paying their own personal bills out of the LLC’s bank accounts. In order to avoid that argument, one should set up a separate LLC bank account for the LLC’s debts and use the money in it only for company debts and obligations. To set up an LLC’s bank account, all that most banks require is the LLC’s EIN and a copy of the Articles of Organization. Obtaining the LLC’s EIN number is generally an easy process and can be done through the IRS’s website: https://www.irs.gov/businesses/small-businesses-self-employed/apply-for-an-employer-identification-number-ein-online
Members of an LLC should only pay themselves salaries, draws, or guaranteed payments from LLC’s bank account. Better yet the LLC could prepare a consent of the members to formally authorize those payments which includes amounts and rationale for the payment. LLC members should avoid paying personal bills from the LLC’s accounts and should also avoid paying themselves when doing so would render the LLC insolvent.
We also recommend that the members of an LLC discuss filing the LLC’s annual returns with their accountant, as not doing so could be used as an argument that the LLC is not keeping up corporate formalities.
Another argument creditors’ attorneys make to try to get around the protection an LLC gives its members is something called “the undisclosed or partially disclosed principal theory”. “In order for an agent who negotiates a contract in behalf of his principal to avoid personal liability he must disclose not only his agency but also the identity of his principal.” Myers-Leiber Sign Co. v. Weirich, 2 Ariz.App. 534, 536, 410 P.2d 491, 493 (Ct. App.1966). “The fact that the agent in making the contract for his principal, instead of disclosing the identity of his principal, uses the tradename under which the principal transacts his business is not of itself a sufficient identification of the principal to protect the agent from personal liability.” Id. citing Alsco Iowa, Inc.; Saco Dairy Co. v. Norton, 140 Me. 204, 35 A.2d 857 (1944). See Ann.: 150 A.L.R. 1303(emphasis added). “It is not the third persons duty to seek out the identity of the principal; rather, the duty to disclose the identity of the principal is on the agent.” Id. citing Stevens v. Graf, 358 Mich. 122, 99 N.W.2d 356 (1959) (emphasis added). “Further, in order to protect the agent from personal liability, it is essential that the principal be disclosed to the third person at the time the transaction is being conducted.” Id. citing Potter v. Chaney, 290 S.W.2d 44 (Ky. 1956) (emphasis added).. “The fact that the agent discloses the identity of his principal after the contract is executed will not relieve him from liability.” Id. (emphasis added).
When entering into contracts it is very important to identify that an LLC member is entering into the contract on behalf of the LLC and not personally. The member should identify the full name of the LLC on any contract entered into and identify that the member is signing as the member or manager of the LLC, depending on the member’s role with the LLC, by including the name of the LLC in the signature block of the contract. If the member does not disclose that the member is entering into the contract on behalf of the LLC, the creditor attorney could argue that his/her client believed that he/she was entering into a contract with the LLC member personally. Whenever signing for the LLC we recommend using your ‘title’: member or manager.
Another item to avoid when operating a LLC is to not sign personal guarantees, if possible. This may be unavoidable if trying to get a loan for a new LLC but one should try to dissuade the creditor from a personal guarantee if possible or ask for a “bad boy” guarantee which would only apply in cases of fraud or insolvency.
Following these simple steps should assist in protecting members/managers of an LLC from personal liability for the LLC’s debts or obligations. The LLC cannot protect one personally if one is committing torts (civil wrongful actions) even if acting on behalf the LLC. To name a few examples, the LLC won’t protect its owners if they commit fraud, commit an assault and battery, cause a car accident while driving on company business, issue bad checks, are negligent in their business dealings or breach a fiduciary duty if one is owed.
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