Personal Liability for LLC Owners
Limited liability companies (or LLCs) offer protections against personal liability, similar to corporations, and provide advantageous pass-through taxes for individuals. For these reasons, LLCs are commonly favored in California.
So, you’re a small business or entrepreneur and you’re thinking, great! Let me go online to a document-preparer site, pay a few hundred dollars and form an LLC! Next, you start engaging in business transactions with your new LLC. Eventually, your LLC, like all other businesses that are actively engaged in business, faces a business dispute. You tirelessly negotiate a resolution with the other party to no end.
The other party files a lawsuit against your LLC and names you, individually, as a separate defendant based on an alter ego theory. You think to yourself, that’s not right! I’m protected by my LLC. You go to your lawyer believing there will be a quick solution to dismissing you, as an individual, from the complaint. Your lawyer empathetically tells you, well your liability as an individual depends. You scream, depends on what?! Your lawyer starts asking you questions:
Lawyer: Did you have regular member meetings, board meetings, membership-interest meetings, file your statements of information, and the like?
You: What are you talking about?
Lawyer: What does your operating agreement state about meetings?
You: What’s an operating agreement?
Lawyer: Never mind. What about an accounting of monies paid to you?
You: Of course, I have an accounting. If I login to my online banking app with my iPhone, you can see all the cash I withdrew from my LLC’s bank account. When I needed money, I simply withdrew cash or used my debit card.
Lawyer: I see. What about separating your business expenses from your personal expenses?
You: Well, there were a few times I needed to buy groceries and simply used my business debit card. Then there were some clothes that I bought, but technically they are work clothes. I also bought a laptop with my debit card.
Lawyer: And do you only use your work clothes and laptop for work?
You: No! That would be a waste.
Lawyer: [Deep sigh.]
Your lawyer proceeds to inform you that,
“[i]n California, two conditions must be met before the alter ego doctrine will be invoked. First, there must be such a unity of interest and ownership between the corporation and its equitable owner that the separate personalities of the corporation and the shareholder do not in reality exist. Second, there must be an inequitable result if the acts in question are treated as those of the corporation alone.” [Sonora Diamond Corp. v. Superior Court, 83 Cal.App.4th 523, 538 (2000), citing to Automotriz etc. De California v. Resnick (1957) 47 Cal. 2d 792, 796 [306 P.2d 1, 63 A.L.R.2d 1042]; [***25] Hennessey’s Tavern, Inc. v. American Air Filter Co. (1988) 204 Cal. App. 3d 1351, 1358 [251 Cal. Rptr. 859]; Alberto v. Diversified Group, Inc., supra, 55 F.3d at p. 205; Calvert, supra, 875 F. Supp. at p. 678.).]
Based on the rule above, there are two key elements to the alter ego theory: (1) a unity of interest to the extent that the corporate (or LLC) separateness ceases to exists between the company the individual principal; and (2) evidence of injustice because of wrongdoing flowing from the acts of the company. [See id. 83 Cal.App.4th 523, 539.]
Factors relevant to the first element include, disregarding legal formalities, failure to maintain minutes or company records, failure to maintain separateness, comingling corporate funds and assets with personal funds and assets, unauthorized diversion of company funds or assets, use of an LLC as a mere shell. [See Associated Vendors, Inc. v. Oakland Meat Co., 210 Cal.App.2d 825, 838-840 (1962).]
Your lawyer tells you that there are some facts you described that tend to support the first element, but asks additional questions to determine if the second key element is supported:
Lawyer: What does your dispute involve?
You: Well you know that laptop I bought? I had it repaired and the bill ended up being much more than I could afford. I tried paying in payments, but the repairperson wanted the entire balance.
Lawyer: How much could it be?
You: Well I had all my family photos on the laptop, and lost all the data. I asked the repairperson to recover the media I lost. That’s why it cost so much.
Lawyer: I see. So, if this was for personal purposes, why did you list the LLC as the party requesting services?
You: I wanted to be protected against liability.
Your lawyer proceeds to describe some instances where alter ego was satisfied: the use of the corporate entity to procure labor, services or merchandise for another person; and the contracting with another with intent to avoid performance by use of a corporate entity as a shield against personal liability. [Associated Vendors, Inc. v. Oakland Meat Co., 210 Cal.App.2d 825, 840 (1962) citing to Temple v. Bodega Bay Fisheries, Inc., 180 Cal.App.2d 279 (1960); Pan Pacific Sash & Door Co. v. Greendale Park, Inc., 166 Cal.App.2d 652 (1958); Engineering etc. Corp. v. Longridge Inv. Co., 153 Cal.App.2d 404 (1957); Wheeler v. Superior Mortgage Co., 196 Cal.App.2d 822 (1961); Claremont Press Pub. Co. v. Barksdale, 187 Cal.App.2d 813 (1960); Shafford v. Otto Sales Co., Inc., 149 Cal.App.2d 428 (1957); Asamen v. Thompson, 55 Cal.App.2d 661 (1942).]
You become frustrated. You inform your lawyer that it would be a stretch to say that entering into a contract under the LLC for laptop repairs is use of the LLC entity to procure labor and services for another person, or that you had intent to avoid performance by use of the LLC entity as a shield against personal liability. [id.] Unfortunately, such a determination is for the trial court. [Associated Vendors, Inc. v. Oakland Meat Co., 210 Cal.App.2d 825, 837-838 (1962).] So, your lawyer explains that there is no immediate way out of the lawsuit, simply based on the facts described, and you will be required to present evidence to rebut plaintiff’s alter ego allegations.
While there are benefits to LLCs, this article illustrates how personal liability can be suffered by individual principals for failing to maintain LLC formalities, account for monies, separate assets and funds, and treat the LLC entity as separate and unique from the individual(s).
NOTICE: This is an attorney communication and a news article. It does not create a legal relationship, nor is it intended to be legal advice. It simply reflects the general opinions of the author. Consult an attorney for legal advice. Pictures in this article are dramatizations.
ABOUT THE AUTHOR: Alan Fassonaki, Attorney at Law
Alan Fassonaki served as Director of Operations for a Los Angeles company before going to law school. He graduated law school with magna cum laude honors. After law school, Alan took on employment at a public company in the East Bay Area as in-house counsel. Alan’s legal focus was contracts law, regulatory compliance, federal and state litigation, and corporate governance (policies, procedures, and the like). Afterwards, Alan started his law practice in Woodland Hills, California, where he now serves businesses with legal matters related to business law and business litigation.
Copyright Fassonaki Law Firm, LLP
More information from Fassonaki Law Firm, LLP
Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer. For specific technical or legal advice on the information provided and related topics, please contact the author.