Piercing the Corporate Veil: Understanding the Limits of LLC Protection

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Transforming your corporation into an LLC has many potential benefits, but it’s important to consider the potential tax consequences.

Relying on your state, the process of converting a corporation into an LLC can be quite easy. But access to an easy conversion process shouldn’t be the driving factor behind a decision to convert a corporation into an LLC.

LLCs offer certain advantages over corporations and vice versa. In determining whether to convert your business structure, it’s important to look particularly at why you want to convert and the practical consequences of such a change.

Why go from inc. to LLC?

LLCs present a number of features that make them a popular choice for numerous small business owners. If you’ve been considering changing your business into an LLC, one or more of these features is likely what drives the idea of conversion attractive.

The following are just some reasons a business owner might decide to convert their corporation into an LLC.

Tax benefits

Businesses taxed as C corporations (which is the situation for most corporations) face what’s known as double taxation. This means you’re taxed twice: first at the corporate level, with tax being levied on the company’s profits, and then again on an individual level, with shareholders being taxed on dividends they’ve received from the corporation.

Numerous small businesses that start out as corporations don’t run into the double-taxation issue immediately since they often don’t make enough profit to distribute dividends to shareholders. However, as your corporation grows and begins to generate greater profits, you may be concerned about how this double taxation will affect you. At this point, the transformation into an LLC might start to look attractive.

This is because LLCs are taxed on a pass-through basis, meaning the LLC’s earnings are “passed through” to the individual LLC members, to be taxed in their writings only. By converting your corporation into an LLC then, you acquire the advantage of pass-through taxation and don’t have to worry about double taxation.

Flexible control options

Companies must be organized according to a fairly rigid structure, with a board of directors to direct overall operations and officers to oversee the day-to-day operational details. Certain decisions require the formal permission of the board and/or the shareholders, evidenced in the form of corporate solutions and shareholder resolutions. These requirements can add to the challenges of managing a corporation, particularly a smaller one that has only a handful of shareholders.

An LLC, on the other hand, lets you run your company without having a rigid command structure. You have the flexibility to decide how your business will be managed, and these rules are then outlined in detail in your LLC’s operating agreement.

If you’ve been seeing the management requirements of running your corporation too onerous—for example, the need to draw up corporate resolutions to document certain decisions may be adding too much to an already overwhelming workload—the increased management flexibility of an LLC may be a better option for your business.

Flexible profit-and-loss distribution

Companies use shares to distribute ownership interests. The main disadvantage to share-based ownership is that each share in a particular class of shares is weighted equally, and profits are received based on the proportionate ownership of the shares issued.

LLCs, on the other writing, have the flexibility to allocate profits differently. While many LLCs do allocate profits based on ownership stake, an LLC also has the option of structuring an alternate profit-allocation arrangement.

Relying on your particular situation may make the conversion from corporate status into an LLC an attractive option. For example, with an LLC, you can allocate a higher share of profits to someone who makes a higher cash contribution to the company without altering the ownership percentage. Once the cash contribution has been paid back through profit distributions, the profit-allocation arrangement reverts back to a percentage-ownership basis.

How do I transform my business from inc. to LLC?

How you go about converting your corporation to an LLC depends on the laws and regulations of the state in which your business is registered.

Streamlined modification

Many forms offer a streamlined conversion process that lets you make the change without certain formalities, such as forming a new LLC, dissolving the old corporation, and transferring the corporate assets and liabilities to the new LLC. If this option is available in your state, it will usually be the fastest and most cost-efficient way to convert to an LLC.

Merger prospect

A merger option may be open in your state if no streamlined option is offered. Under this method, you will have to form a new LLC, create a merger contract to implement the transfer of ownership rights from shares to LLC membership units, and, depending on your state’s rules, dissolve the corporation. Unlike the traditional method below, however, your company’s assets and liabilities will automatically be transferred to the new LLC.

Traditional transformation

A traditional conversion is the most demanding of the three methods. As with the merger option, you’ll have to create a new LLC and exchange shares for LLC membership interests. You’ll also have to do all the paperwork necessary to transfer corporate assets and liabilities to the new LLC, as well as dissolve the old corporation.

What are the functional consequences of converting my corporation into an LLC?

Basically speaking, converting your corporation into an LLC will eliminate the requirement to hold directors’ meetings and shareholders’ meetings and draw up resolutions documenting certain decisions. Overall, it will help you to run your company without having to adhere to the more rigid requirements of managing a corporation.

Transferring ownership interests is more difficult with an LLC than with a company. With an LLC, you have to transfer the LLC membership claims, while the transfer of ownership interests in a corporation is as easy as transferring shares.

Nevertheless, the most important consequence of converting a business into an LLC lies in the potential tax impact. Regardless of the method, you use to convert into an LLC, from a tax perspective, the transfer of corporate assets is seen as a liquidation or sale of the corporation’s assets. If any gain has been accumulated in the value of these assets—a likely scenario for most corporations—it will be taxed at both the corporate level and in the hands of the shareholders.

These potential negative tax consequences are an important consideration in deciding whether to convert a corporation into an LLC. In many cases, the costs of this additional tax burden vastly outweigh any help you may receive from the conversion.

It’s worth conferring with a tax expert before deciding to convert so you can assess whether a conversion is an optimal choice for your business.

You may have many causes to convert your corporation into an LLC and, depending on your individual state, the actual formal conversion process may be streamlined and cost-effective. However, the tax consequences of a conversion should be an important factor in your decision.

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One of the most important reasons to form a limited liability corporation (LLC) is to protect yourself from personal liability for the business’s debts. But that protection can disappear if you fail to separate your personal finances from those of the business. That’s why simply setting up an LLC isn’t a foolproof method for protecting yourself. If you don’t manage your LLC properly, a person or business can come after your personal assets. This is called piercing the corporate veil.

There are two key situations that make it possible for a creditor to pierce the corporate veil and come after your personal assets:

1. Lack of Real Separation Between the LLC and Yourself

When you set up an LLC, it’s important that you run it like a real business. The following situations place you at risk and fail to keep legal separation between you and your LLC:

  • Using the LLC’s bank account to pay your personal bills
  • Depositing checks made out to the LLC into your personal bank account
  • Failing to keep minutes and business records for the LLC
  • Not creating bylaws for your LLC
  • Setting up your LLC with insufficient capital

If you don’t make it clear that the LLC and you are legally separate entities, you are in danger of losing the corporate veil, so be sure to observe corporate formalities.

2. Fraud or Wrongful Actions

If you do anything under the guise of your LLC that plays fast and loose with the law, you can jeopardize the corporate veil. Examples of such actions include:

  • Taking out loans you know you can’t repay
  • Defrauding people or businesses
  • Breaking the law

A court will have little respect for the corporate veil if your LLC disregards the law. If your LLC commits fraud, you could personally be in hot water.

How Courts View LLCs and True Separation

The corporate veil is only pierced if a court makes a determination that it should be.

The court must determine that there is there no true separation between the members and the LLC and that some kind of fraud has taken place. In most situations, the court requires there to have been “serious misconduct.”

Once that determination is made, the court then allows a creditor to access the member’s home, personal bank account, investments, and other assets to pay off any judgments that are entered against the LLC. All of the member’s personally owned assets are then up for grabs.

When Personal Creditors Come After Your Business

Another situation to be aware of is when personal creditors access your LLC assets to satisfy your personal debts. For example, if Marco owns Cool Sunglasses LLC, which he runs as a business, but he personally goes into bankruptcy, his creditors can access his ownership interest in the LLC.

There are three ways this can happen:

  • The court can order the LLC to pay the creditor any money that is due to the member from the LLC.
  • The court can allow the creditor to foreclose on the LLC member’s ownership portion of the LLC.
  • The court can order that the LLC be dissolved.

An LLC provides important protection from personal liability, but you have to be careful to maintain a separation between your personal financial life and the LLC. By ensuring that your LLC is always acting in accordance with the law, you can ensure that you keep those protections in place.

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