If you plan to start or have recently started your own business and are considering a single-member LLC (i.e., a limited liability company of which you are the sole owner), it is tempting to cut corners on the formalities, cost and time investment that may be associated with administering a “real business”. After all, no one can dispute profits, control or any aspect of the company with you, so why do you need the hassle? Successful or not – including the scary and exhilarating bits – it’s all yours.

The main problem if you fail to treat your LLC as a real business is that, when you actually need the limited liability protection that the LLC is meant to afford, the courts may not treat it as one either.

[Note: This post was written while I was a practicing attorney running a solo law practice. Since April 2015, I have been working with attorney, executive and entrepreneur clients as a career coach and writer, and I am not currently available for legal engagements.]

The Concept of Limited Liability

If you are going into business for yourself, there is no requirement to form an LLC or any other legal entity. There are quite a number of small businesses that operate as sole proprietorships, especially in the early days of the business when there is little or no revenue generation. The reasons to form an LLC or other entity vary, from simply appearing “more professional” to raising capital or engaging in tax planning, but obtaining limited liability status is certainly a key motivator.

In contrast to the single-member LLC, a sole proprietor simply operates a business in his or her own name. Let’s say Katie Lynn designs handbags, for example, and sells them from her home. Her business transactions are all done through her own name. Katie has personal liability for her own conduct as well as any debts of her business. If she purchases fabric, rents display space or incurs other liabilities that she later cannot afford to pay, Katie’s creditors can come after her home or other personal assets.

If Katie forms a limited liability company – let’s call it KL Designs LLC – she can now take a step back from the business if – and this is the important point to note – she takes appropriate care in the operation of her LLC. Simply forming an LLC one day and making no other changes to her business operations will not afford Katie the protection she expects. She needs to run KL Designs LLC not as an extension of Katie Lynn but as a separate entity or “legal person”.

Veil Piercing

The risk that Katie now runs, as the sole owner of an LLC, is that she has spent time and money to create KD Designs LLC but will be liable for its debts nonetheless. To be clear, there are instances where an LLC owner can be personally liable despite any entity status, including:

– personally and directly injuring someone,

– personally guaranteeing a business loan or other liability, or

– intentionally or recklessly committing fraud or illegal acts.

An LLC owner can also be personally liable if he or she does not treat the entity as a separate legal entity. In that instance, a court can hold that Katie or another business owner is essentially operating as a sole proprietorship and disregard the LLC status. Below are some ways sole member LLCs can protect themselves against “veil piercing”, which is the legal term used to analogize that the entity is simply a facade or “veil” covering the owner rather than shield against liability.

Operating Agreement

The central document for an LLC is the operating agreement. An operating agreement sets forth the obligations of the member(s) with respect to ownership percentages, capital contributions, profits and losses and other rights and responsibilities. It also overrides any default rules on the governance of LLCs in the relevant jurisdiction, which may or may not be what the owner(s) intended. As a sole owner of an LLC, having an operating agreement and following what it requires to authorize or take action by the entity are the first steps to demonstrating that the business is separate from one’s individual affairs.

Funding the LLC and Insurance

Undercapitalization – i.e., lack of sufficient funds to operate the business – is another reason a court may pierce the veil of an LLC and hold the owner(s) personally liable for the company’s debts. LLC owners need to invest sufficient cash in the business to fund its expenses and should hold sufficient liability insurance to cover lawsuits and claims (which will also be available to cover instances where the limited liability status is not respected).

Separation of Business and Personal Assets

An LLC owner should obtain a federal employer identification number (EIN) and keep bank accounts and financial accounting separate for the LLC and his or her personal assets. The absence of corporate records and commingling (mixing) of business and personal assets are two factors that courts consider in determining whether the piercing-the-corporate-veil test is met.

Transacting Through the LLC

All agreements and business transactions should be conducted through the name of the LLC. If we consider our example above, all contracts, invoices and other documents that Katie enters into on behalf of her handbag business should be in the full name of KL Designs LLC (including the “LLC” designation) and signed by Katie in her capacity as president (or another title) of the company.

The above considerations are crucial for any owner of an LLC, including a single-member LLC, who wants to preserve the limited liability status that an LLC is intended to afford.

None of the information posted on this site constitutes legal advice or forms an attorney-client relationship. This is a public forum. Please do not post confidential or fact-specific information regarding your legal questions on this site.

Imagine, as I was asked recently, that you were an ex-employee of a company and attempting to determine whether you would prevail in a certain lawsuit. The situation involves a non-competition agreement (non-compete) you signed with a company, and you do not believe you should be bound by it.  The company is suing you to enforce it. The non-compete says it is “subject to an employment agreement to be completed within 30 days.” The employment agreement, in fact, was never signed.

Is the non-compete binding? In other words, is the enforceability of the non-compete subject to the existence of an executed employment agreement or are the provisions simply subject to contrary language in an employment agreement, if completed and signed within the 30-day period? Obviously, these are two conflicting interpretations of the same language, and either could be valid. A separate question would arise if an employment agreement was in fact executed, but it was done so more than 30 days after the employment agreement.

[Note: This post was written while I was a practicing attorney running a solo law practice. Since April 2015, I have been working with attorney, executive and entrepreneur clients as a career coach and writer, and I am not currently available for legal engagements.]

At the outset, there are many preliminary questions to ask before considering the potential outcome of the case, including the following:

–       In which jurisdiction was the agreement signed, and are non-competition agreements binding in the jurisdiction?

–       Was there sufficient consideration to create an enforceable agreement?

–       Is the agreement otherwise enforceable as drafted?

–       Does any other language in the agreement itself contradict the language above? For example, is there an “integration” clause that says the agreement contains the entire understanding of the parties with respect to the subject matter of the agreement?

–       What interest is the company trying to protect (e.g., confidential information, competing employment, customer lists or another restriction)

–       In what circumstance did this arise, i.e., were you fired or did you leave voluntarily?

–       Have other cases been decided in the relevant court(s) that deal with the same or a similar point?

–       Do we know anything else about the intent of the parties (you and the company) when the non-compete was signed?

–       Do other employees have non-competes with the company and are these generally enforced if violated? Do you know (or can you find out) if they contain similar language?

The questions above and others would help determine your likelihood of prevailing in the lawsuit.  Assuming the plain language of the agreement and the limited facts above, I believe you would have a strong argument that your non-compete is not an enforceable agreement, because the formation of the contract was subject to a condition that was never fulfilled, i.e., the execution of an employment agreement within 30 days. The company would counter that you were employed nonetheless, and that “subject to” language is therefore superfluous.

If this case were actually at trial, you would need to consult further with a competent attorney to determine what goals the company had in bringing the lawsuit against you and what strategy should be employed to attempt to diffuse, fight or settle the suit.

Of course, there is another crucial lesson to take away from the above scenario. When you draft a contract, you have to get the language right, and you have to do what you say you’ll do. In other words, good drafting and attentive follow-up, by you and/or your lawyer, are essential.

Lawyers often get a bad rap for focusing on “legalese” and “fine points”. However, thousands and sometimes millions of dollars are spent trying to interpret what people meant when they wrote something, and which party has the better argument that its interpretation of a clause is the correct one. While lawyers cannot foresee every situation that may arise and how to draft a “bulletproof” agreement that will withstand any dispute, experienced ones can steer you out of circumstances in which off-the-shelf or borrowed contract language turns out to be penny wise and pound foolish. Don’t assume that language you found on the Internet or that “worked” for (or was never tested by) your brother-in-law’s business in another state five years ago will work for you today.  Even language recommended by your attorney to use with a previous employer may not fit your current employment arrangement, since the circumstances may be different

Finally, if your lawyer was paying careful attention when the above (hypothetical) non-compete was drafted, you would not be in this scenario. The non-compete would have specified whether a signed employment agreement was a condition precedent to an enforceable non-compete or simply governed in the case of conflicting provisions. In addition, the employment agreement referenced would have been signed and kept on file, or the non-compete would have been amended to delete or change the reference if the employment agreement was not signed in the requisite time period.

None of the information posted on this site constitutes legal advice or forms an attorney-client relationship. This is a public forum. Please do not post confidential or fact-specific information regarding your legal questions on this site.