LLC Operations: Shielding Owners from Personal Liability

     This is the last of a series of three posts covering LLC basics.  In two prior posts (March 21st and May 19) we discussed the necessity of a good operating agreement and taxation basics for LLCs.  In addition to pass-through taxation, most LLC owners form LLCs intent on insulating their personal assets from exposure to liabilities incurred by the business.  In a lawsuit against an LLC, a plaintiff's attorney may ask the court to hold LLC members personally responsible for the debts, obligations or liabilities of the LLC; this is referred to as "piercing the corporate veil."  Colorado law concerning this topic, and the grounds for disregarding the liability shield afforded to business owners by LLC is somewhat befuddled.  Many owners are exposed to personal liability for the debts and obligations of their LLCs because they make a common mistake; after creating the LLC and opening for business, they quickly forget all about the entity and operate their companies informally and inconsistently.  Their perception is that registering the entity with the Colorado Secretary of State and paying the annual fees is all they have to do to enjoy the limited liability of operating under the guise of an LLC.  That perception is wrong.  Their LLC is form over substance and as such is susceptible to being viewed as the alter ego if its owners rather than a truly separate entity.

     In deciding whether to pierce the corporate veil and impose personal liability on LLC owners, Colorado courts apply what is known as the alter ego test.  As the name implies, the initial analysis centers around whether the business entity is truly a separate "entity" or is in fact the alter ego of the owner.  In Colorado this involves an 8 point balancing test.  Factors courts consider include: whether the the LLC is operated as a distinct business entity; whether assets and funds are commingled; whether adequate corporate records are maintained; whether misuse by an insider is likely due to the nature and form of the LLC's ownership and control structure; whether the LLC is marginally capitalized; whether the LLC is a mere shell with no real assets; whether owners disregard legal formalities such as meetings, minutes, approval resolutions and consents in accordance with the LLC's operating agreement and whether corporate funds or assets are used for non business purposes.  No single factor is determinative or holds more weight than another.  That is reflected by the Colorado statute on point, C.R.S. 7-80-107(2) (2016) which states, "the failure of a limited liability company to observe the formalities or requirements related to the management of its business and affairs is not, in itself, a ground for imposing personal liability on members for liabilities of the limited liability company.    

     In Colorado, traditionally, in addition to proving an LLC fails the alter ego test, plaintiff had to establish that the LLC was used to carry out a fraud or overcome an otherwise rightful claim.  However, in recent years, Colorado courts seem to have adopted a looser standard for piercing the corporate veil and done away with this second requirement.  In Martin v. Freeman (Colo. App. 2012), the Colorado Court of Appeals reasoned that "neither wrongful intent or bad faith" are not necessary to satisfy the second part of the piercing test.  The practical effect of this is that by being a party to litigation where the plaintiff seeks to pierce the corporate veil, an LLC is exposed to liability if it fails the alter ego test.  In 2009, in Sheffield Services Company v. Trowbridge (Colo.App. 200), the Colorado Court of Appeals extended personal liability of an LLC to an LLC's managers in addition to the LLC's owners.  It should be noted that the Martin case concerned a single member LLC but logic dictates that it should apply to all manner of LLC's.  The Sheffield case was a clear extension of the applicable law as the relevant statute, cited above, is expressly limited to members.  

     From a practical standpoint, all of this means that in Colorado its easier than ever for the liability shield afforded by LLCs to be disregarded if the LLC's owners treat the entity as a mere alter ego and fail to operate it as a truly separate and independent entity from themselves.  As lawyers, its imperative for us to advise our clients that creating an LLC is merely the beginning and proper operation as truly separate entity is essential to maintain the liability shield that they assume is in place by virtue of operating their business as an LLC.  In addition to creating the LLC and drafting an operating agreement, clients need sound advice on proper procedures, safeguards and formalities in the day to day operation of their business so that they do not unintentionally expose their personal assets to the liabilities and debts of the LLC.