In the Commonwealth of Pennsylvania, as in many other states around the country, the formation of an LLC is an option available for business owners who wish to protect their personal assets from liability. As with a corporation, the members of an LLC generally are not personally responsible for debts or liabilities incurred by the business. In addition to affording protection to an LLC member’s personal assets, the form of an LLC is attractive to small business owners for a variety of other reasons. Such reasons include the flexibility that inheres with the operation of the LLC, as well as the lack of more formal requirements and restrictions, which must be strictly complied with when operating an incorporated entity in order for owners and managers to avoid personal liability.
However, in spite of the comparatively lower burden on LLCs to create and adhere to internal rules, LLC owners should remain wary of succumbing to the impulse of treating the LLC as an extension of the owner. This is due to the growing body of case law in Pennsylvania that subjects LLCs to the same test for piercing the corporate veil as traditional corporations. In instances where a court chooses to pierce the corporate veil of an LLC or corporation, the members or owners of the business can be found personally liable for the debts and obligations of the business. To avoid such a dramatic imposition of liability, which oftentimes forces businesses into insolvency, it is imperative that LLC members take seriously the organization’s internal rules as well as the court-prescribed factors for determining when it is appropriate to pierce the veil of an LLC.
The following factors have been used by Pennsylvania courts in determining when to pierce the veil of a corporation and LLC:
- Whether the company was undercapitalized at the time of its formation;
- Whether the principals adhered to LLC or corporate formalities;
- Whether dividends were paid to the principals or members of the LLC;
- Whether the debtor corporation was insolvent at the time the debt in question was incurred; and
- Whether the dispute lies in tort or in contract;
The over-arching theme throughout these factors is a determination by the court whether the corporate form was being used as merely a shell or alter ego of the principals and/or members. Courts are increasingly prone to pierce the corporate veil when an owner fails to invest sufficient capital at the inception of a venture, disregards whatever corporate formalities have been created, pays dividends to him or herself and thereby leaving a creditor to go unpaid.
The court’s reasoning in such circumstances is that the business owner should not be shielded from personal liability when they have abused the corporate form and, in essence, defrauded a creditor. It is for this reason that business owners who choose to operate under the form of an LLC must be cognizant of the rules they put in place for themselves and meticulously follow them. A failure to do so could cause that individual not only to lose their business, but their home and whatever personal assets the use of the LLC form was intended to protect. If you are a small business owner who would like to discuss the potential ramifications and requirements of entity formation, or an LLC member concerned with personal liability, contact the attorneys at Rick Linn, LLC today to schedule a complimentary consultation.
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