Why do people form business entities for their small business? The answer is very simple. While they believe in their business idea, they want to protect themselves from any debts or lawsuits should the business have problems. For those forming an LLC with only one owner, this shield is often easily penetrated with disastrous results.
The limited liability company, better known as the LLC, is a unique business entity choice. It is actually very new to the United States. Wyoming “imported” it from Europe in the late 1970s. It didn’t catch on in the other states until an IRS ruling in the late 1980s determined it could be taxed as a partnership in some ways. This appeared to make it a good choice for small businesses. Over the next 20 years, the LLC has slowly become an accepted business entity choice and law has been developed around it.
One set of law that has been developed is the idea of lifting the corporate veil. This is taken directly from corporate law, which has been around for hundreds of years. The idea is that the protective shield will be lifted and expose the owners to personal liability if the corporate entity is determined to be a sham by the court.
So, how does the court come to this determination? Well, there are many factors that are looked at. One area that is key is whether corporate formalities are followed. Corporate formalities refer to the documented running of the business entity. Put in English, this means you need to have documentation in the LLC corporate book showing that membership interests were issued, individuals were elected to certain position and an operating agreement was agreed upon.
This is not a problem in a single member LLC formed by an attorney. He or she will create the paperwork part and parcel to the formation. If you paid a non-attorney [online service], it can be because you usually receive a bunch of blank forms or a CD that you are supposed to fill out. This results in two problems. First, almost nobody fills out the forms! Second, the forms are rarely designed for a single member LLC, which is where the trouble really starts.
Let’s say you decide to start a business and order an LLC from an online site. You get the LLC a few weeks later and start conducting business. A few years later, you get sued. You are asked in a deposition if you used an attorney or online site to form the LLC. You answer honestly about using an online site. The suing party amends their complaint to include a claim that the corporate shield should be set aside and you should be personally responsible for the debt. You are then compelled to turn over the corporate book. What is found in it? A bunch of blank forms. Even worse, the forms are designed for an LLC owned by two or more people.
In this scenario, you’ve failed the corporate formality test. There is a very good chance the court will find the business entity to simply be a sham. That means you will be held personally liable for the debts incurred in the lawsuit.