Seven Critical Mistakes Real Estate LLCs Make (and How to Avoid Them) — Mistake #4: Stepping into “Alter Ego” Liability
California law normally respects the “separateness” of business entities. It is widely accepted that business is conducted through entities as an appropriate way of limiting liability.
“Alter ego” liability is the exception, and allows a creditor to “pierce the corporate veil” and hold owners personally liable for the entity’s debts.
Luckily, this fate can be avoided.
MISTAKE #4: Stepping into “Alter Ego” Liability
Courts usually look at two main factors when making an alter ego determination:
- a unity of interest/ownership (actions that defy the “separateness” of the entity)
- an inequitable result (usually featuring at least some degree of bad faith)
An entity’s undercapitalization is probably the single most common ground leading to alter ego liability.
Is the LLC able to meet its obligations as they are incurred? Can the LLC point to a “track record” of paying its debts? The LLC doesn’t necessarily need every penny of a commitment “in the bank” when signing a contract, but there should at least be a verifiable income stream or legitimate expectation of sufficient income.
Courts usually focus on the LLC’s capitalization at the time it incurs the obligation at issue. Having your LLC enter into a contract that it might not be able to perform (due to contingencies with the expected income stream or otherwise) is a sometimes necessary business risk. But having your LLC enter into a contract that it unquestionably will not be able to perform (due to undercapitalization) is an admission ticket to alter ego land.
Commingling / Diversion
If undercapitalization ranks first in the alter ego risk spectrum, commingling and diversion are next.
The entity’s finances should be kept completely separate from its owners or affiliated entities. Separate accounts. Separate books and records.
The owners should never “dip into the LLC piggybank” except through legitimate distributions. LLC funds should never be used to pay personal expenses, except for reimbursements authorized by the Operating Agreement. And the LLC’s business should always be conducted in the name of the LLC (with contract signature blocks correctly identifying the manager).
Any time transactions occur between the LLC and its members, or between the LLC and affiliated entities, there should be adequate consideration (value) and documentation (paper!) to safeguard the aura of legitimacy.
The failure to follow “corporate formalities” is usually not enough, alone, to support an alter ego finding. Courts respect the fact that LLCs are, by nature, less formal than corporations.
This is reflected in California’s Revised LLC Act, which states that as long as an LLC’s Operating Agreement doesn’t require meetings, then the LLC’s failure to hold meetings cannot be a basis for alter ego liability.
That being said, even if meetings or minutes aren’t required, consider doing them anyway. What better way can you think of to document your compliance with the Operating Agreement’s requirements for voting and member approval of certain actions?
Minutes can be a valuable form of “alter ego insurance.” They can also speak volumes regarding the intent behind certain actions, and minimize the risk of a “bad faith” ruling.
Minutes have the additional benefit of defusing other allegations besides alter ego, especially fiduciary duty claims. Often times, the LLC minutes will demonstrate the members’ unanimous knowledge and ratification of certain LLC decisions that a disgruntled member will later claim breached some fiduciary duty.
Respect the Operating Agreement
Compliance with the provisions of the Operating Agreement can go a long way for an alter ego defense.
Owners who show their respect for the entity by diligently following “the rules” established by the Operating Agreement are less likely to face alter ego liability.
Employ the “Smell Test”
The alter ego doctrine is fundamentally rooted in equity and fairness. Judges are often swayed by the foul odors arising from offensive conduct.
Any business owners with doubts about their potential alter ego liability arising from a certain set of facts should put themselves in the position of an outsider hearing the story fresh. Would it make you uncomfortable to explain the facts to your mom? Your spouse? Your child? If yes, then the story will probably make a judge uncomfortable too.
Special Issues with “Series LLCs”
About a dozen states (including Delaware and Nevada) allow the formation of “series LLCs.” California does not … yet.
A “series LLC” is a structure allowing for the compartmentalization of distinct assets and liabilities. The LLC can have one Operating Agreement and some consolidated functions, but each series within the LLC can be assigned different assets and associated liabilities. Think of an enterprise that acquires and manages various real estate properties. Rather than form a separate LLC for each property, a series LLC would hold each property in a separate series. The reputed advantages of the series LLC structure include reduced costs (eliminating the need to form and dissolve multiple LLCs) and some operational streamlining (reduced entity paperwork; potential tax-free transfers; potential consolidated reporting).
All sounds good, BUT …
The “series LLC” structure presents new, untested alter ego issues. Consolidated reporting or a common operating bank account might be viewed as evidence of commingling or undercapitalization, depending on the surrounding facts. Creditors might claim they were duped into signing a contract with “the LLC” when only a “series within the LLC” is legally responsible for the obligation. So far, courts of appeal have offered very little guidance as to how series LLCs will be handled in the alter ego equation.
Why bother to form an entity if you’re going to ignore it and lose all of the liability-limiting benefits?
Avoid alter ego liability by following the simple rules above, all geared toward honoring the separateness of the LLC from its owners.
And don’t forget the smell test.
Next post in series (coming soon) … MISTAKE #5: Misunderstanding Secured Loan and Guaranty Rights/Liability
Prior posts in this series:
MISTAKE #1: Choosing the Wrong Business Partners
MISTAKE #2: Skimping on the Formation and Operating Documents
MISTAKE #3: Ignoring Member Rights and Duties