Incorporation or LLC?

May 2001
by Ivan Hoffman, B.A., J.D.

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Ivan HoffmanIvan Hoffman is an Internet law, publishing, copyright, corporate training and online education, trademark, and music attorney, practicing for over 28 years.  He practices in the Los Angeles area.  His web site is www.ivanhoffman.com. You may reach him at ivan@ivanhoffman.com. This article is not intended as legal advice. The specific facts that apply to your matter may make the outcome different than would be anticipated by you. You should consult with an attorney familiar with the issues and the laws. This article does not create any attorney client relationship.


If you’re contemplating incorporating or setting up a limited liability company (LLC) to operate your business, there are some significant legal issues you must resolve. Please note that these decisions are integrally tied in with accounting and tax issues as well, and thus it is important

that your attorney and you have continuing discussions with your certified public accountant about the implications of both the initial and subsequent decisions. Please note as well that while this article deals with general legal issues applicable to corporations and LLCs throughout the country

and specifically to the law of California, the actual formation of the entity is generally governed by state law. Thus you should consult an attorney and a CPA in your state.

Similarities & Differences

There is a false notion, held by non-attorneys, that merely establishing either an LLC or a corporation confers an insulation from personal liability as to third-party creditors. This is not the case for either entity.

In both an LLC and a corporation, the individual members or shareholders can, under certain circumstances, shield themselves from personal liability to third parties and limit their liability to their membership or shareholder investment in the LLC or the corporation. However there are clear limits to this “shield,” and if the “shield” is not upheld, creditors can file lawsuits against the shareholders seeking to “pierce the corporate veil” alleging “alter ego” and similar theories in the instance of LLCs and hold these members or shareholders liable for what might otherwise be debts and obligations of the LLC or corporation.

California Corporations Code, section 17101 provides in part:

(a) Except as otherwise provided in Section 17254 or in subdivision (e), no member of a limited liability company shall be personally liable under any judgment of a court, or in any other manner, for any debt, obligation, or liability of the limited liability company, whether that liability or obligation arises in contract, tort, or otherwise, solely by reason of being a member of the limited liability company…

(b) A member of a limited liability company shall be subject to liability under the common law governing alter ego liability, and shall also be personally liable under a judgment of a court or for any debt, obligation, or liability of the limited liability company, whether that liability or obligation arises in contract, tort, or otherwise, under the same or similar circumstances and to the same extent as a shareholder of a corporation may be personally liable for any debt, obligation, or liability of the corporation; except that the failure to hold meetings of members or managers or the failure to observe formalities pertaining to the calling or conduct of meetings shall not be considered a factor tending to establish that a member or the members have alter ego or personal liability for any debt, obligation, or liability of the limited liability company where the articles of organization or operating agreement do not expressly require the holding of meetings of members or managers.

This apparent conflict is no conflict at all except to the unaware. Section (a) provides the “shield” only against the mere allegation or proof that a person was a member (or shareholder in the case of a corporation) and nothing more. The more pertinent and often overlooked provision is section (b) which says that a member of an LLC can be liable to the same extent as a shareholder of a corporation under the law of “alter ego.” To avoid this, the LLC or corporation must be treated as a completely separate entity from its members or shareholders. The entity must not be treated as merely an extension of the member or shareholder. This means that the member or shareholder cannot simply withdraw monies from the LLC or corporation at will. As a director member or officer, the member or shareholder can receive a salary, payable as the member or shareholder determines, provided it is reasonable. The member or shareholder can reimburse him or herself for LLC or corporation business expenses incurred on behalf of the LLC or corporation including the costs of organizing the LLC or corporation, upon presentment of proper receipts. The member or shareholder cannot, however, pay non-LLC or non-corporation or personal bills out of LLC or corporation funds. There must be a separate bank account for the LLC or corporation, and the member or shareholder may not deposit any of the members or shareholders personal monies in that account. The name of the LLC or corporation–including the designation “LLC” or “Inc.”–must appear on all contracts, checks, correspondence, and other LLC or corporation writings. All contracts have to be in the name of the LLC or corporation.

Failure to observe this separateness, whether of an LLC or a corporation, can result in the liability of the member or shareholder.

More on Formalities

But there is another wrinkle that is one of the differences between LLCs and corporations, and that has to do with observing other “formalities” of the operation of the particular entity.

One of the factors that creditors point to in seeking to hold shareholders or members liable for corporate or LLC obligations is that the formalities of the entity were not observed. In the corporate setting, this means that both regular and annual meetings were not held or that appropriate waivers

of notices were not signed and filed. As section (b) above indicates, one of the exceptions to the liability issue in the LLC context is that the failure to observe those formalities cannot be used by such creditors as proof of the alter ego liability provided that the articles of organization or the operating agreement do not expressly require the holding of such meetings. Thus, when you form your entity and prepare these documents, you must be absolutely certain that the “boilerplate forms” that many of you use do not state that such meetings are required and that when you prepare your articles, you expressly exclude the requirement of such meetings.

Additionally, the California statute states in subsection (c) that a member of an LLC can be liable if the member has expressly agreed to be so liable under a written guarantee and, of course, if the member or shareholder has participated in what the law refers to as “tortious conduct.” This refers to the acts of the member as a participant in an act of fraud or misrepresentation, intentional or otherwise, or other such conduct that is more than a mere breach of a contract for example.

Conclusion

There are other bases for liability of members or shareholders, but I have wanted to focus on these threshold issues that are often woefully misunderstood. And again, the question of whether to choose either of these entities as a manner of doing business is also a function of tax and accounting issues that should be resolved among the client, the attorney, and the CPA.

The moral here is that the unaware can find themselves facing lawsuits against them personally and their assets, beyond their interest in the LLC or corporation. Setting up an LLC or a corporation to insulate oneself from liability is not a “slam dunk” and requires some knowledge regarding the actual formation and then operation of the entity. Using self-service, copy-and-paste corporate or LLC kits or software may lead to unintended and potentially disastrous results.

This is not a do-it-yourself project.

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