Volume 14, Number 4 · October 2004

LLCs on the March

by Jonathan G. Higie, Esquire

The early part of the 21st century has seen the proliferation of a new business entity in Pennsylvania. Limited Liability Companies (LLCs) have become "all the rage" for people in search of a simplified substitute for a corporate entity which still purports to provide the same degree of liability protection as do traditional corporations. Annual LLC filings in Pennsylvania increased from 500 to 13,000 from 1995 to 2002. Newly formed business corporations dropped in the same period by 2,000 to 17,400 per year.

This increase in number of LLCs formed in Pennsylvania is due in large part to the perception that LLCs are more simple and less expensive to create, are easier to administer from a record-keeping standpoint and offer the same tax advantages and legal liability protections as traditional Subchapter S Corporations. Because LLCs are a relatively new type of business entity, however, questions have arisen as to whether or not they truly provide all these benefits and especially whether they provide the protection from legal liability that traditional corporate status provides.

One question is the effectiveness of the limited liability shield. Traditional corporations provide legal liability protection to its individual officers, directors and shareholders from acts of the corporation as long as the corporation was treated as a separate entity from the individuals operating it. Courts have found, however, that some corporations are formed for questionable reasons or are operated as a "front," in a manner which allows its individual operators (directors, officers, shareholders) to be held personally liable for debts and acts of the corporation. When those individuals are held legally responsible for corporate acts, it is known as "piercing the corporate veil". The same concept applies to LLCs under their enabling law.

Because LLCs are touted as being more simple entities that require less record keeping, individuals who are involved in LLCs may have the false impression that corporate formalities need not be followed with LLCs. Peacock Keller strongly advises against this impression. A single case in Allegheny County in 2002, ATS v. Corn-Net LLC, carefully analyzed whether the defendant LLC had kept the "veil" in place. Given the large number of LLCs formed in Pennsylvania over the past few years, it is only a matter of time before courts become more involved in "veil piercing" cases involving LLCs.

To avoid being held personally liable for the debts and acts of an LLC, the members must be diligent in respecting the separate business form of the LLC. This requires a filing of a Certificate of Registration with the Pa. Department of State and the preparation of an effective Operating Agreement. The LLC must be able to document that it is treated as a separate entity from the acts of its individual members or managers. The following is a list of actions that must be taken by members and managers of LLCs to avoid being held personally liable for the LLCs debts and acts: (1) proper capitalization; (2) active members and managers; (3) observing corporate formalities; (4) maintaining separate company records; (5) keeping separate bank accounts; and (6) avoiding improper loans to members or managers. While each LLC is different in its structure and operation, these guidelines generally apply to most LLCs.

Let me illustrate. The LLC must be properly capitalized from the start, i.e., there must be sufficient assets (either cash or personal property) which allows the entity to conduct and operate the business. The members and especially the managers must be involved in the business and not just "named" parties in the operating agreement. Company records, i.e., minutes of meetings, must be kept and all agreements must be entered into in the company name and maintained with all other company documents. It is essential that the LLC operate its financial affairs out of at least one separate bank account and pay all company debts out of that account. The company funds should never be commingled with individual funds of members and managers. Any loans from members or managers to the LLC (or vice-versa) should be documented and not forgiven without professional legal or financial advice.

Members and managers of LLCs must be mindful of each of these guidelines in order to avoid the risk of losing protection against individual liability. If an individual (or several individuals) treat the LLC as their own personal entity (similar to a sole proprietorship or a general partnership) they risk being held personally liable for the debts and acts of the LLC. Because many LLCs have been formed by people who have been "sold the idea" but who have traditionally operated as sole proprietors and partnerships, it is especially important that these guidelines are followed and documented.

There is presently very little case law in Pennsylvania which deals with the extent to which LLCs will be subject to the "veil piercing" theory. What is clear, however, is that merely filing a certificate of registration for an LLC, without more, will likely not be sufficient to protect LLC members and managers from individual liability. The near future, however, will surely bring more judicial guidance. Peacock Keller hopes that its LLC clients will not be parties to these cases and, if the above guidelines are followed, they will have achieved significant protection.

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