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21 • 2016

Does a Corporation or a LLC Provide Better Liability Protection?

One of the primary purposes of forming a corporation or a limited liability company is to limit shareholders’ or members’ liability for the entity’s debts.[1] But does one form of business entity provide better liability protection than the other? The differences, if any, are so small that they should not be a principal consideration in deciding which type of entity to form.

Because one of the principal benefits sought to be obtained from incorporating is shielding shareholders from liability, it has long been recognized that “[a] corporation, and not its shareholders, is presumed to be liable for corporate acts.”[2] Stated conversely, “[t]he general rule . . . is that a corporation exists independently of its owners, who are not personally liable for its obligations.”[3] Although corporations are often called “creatures of statute,”[4] shareholders’ protection from liability through adoption of the corporate form is usually recognized at the common law, that is, by judges, rather than in explicit provisions in states’ corporation statutes.

By contrast, the protection from liability for the members of a limited liability company is explicitly called for in states’ LLC statutes. New York’s provision is typical:

Neither a member of a limited liability company, a manager of a limited liability company managed by a manager or managers nor an agent of a limited liability company (including a person having more than one such capacity) is liable for any debts, obligations or liabilities of the limited liability company or each other, whether arising in tort, contract or otherwise, solely by reason of being such member, manager or agent or acting (or omitting to act) in such capacities or participating (as an employee, consultant, contractor or otherwise) in the conduct of the business of the limited liability company.[5]

There are two main exceptions to the general rule of limited liability for shareholders/members. First, while a person may not be liable for debts arising in tort solely by being a shareholder or member of a business entity, a person is always liable for his or her own tortious actions, whether acting as a shareholder of a corporation or a member of an LLC.[6]

Second, the law has long permitted a shareholder to be held personally liable for the corporation’s debts in circumstances where it is appropriate to “pierce the corporate veil.”[7] Because limited liability for LLC members is mandated by statute, rather than at the common law as for corporations, there has been some question as to whether it would be appropriate to pierce a limited liability company’s “corporate” veil in order to impose liability on its members for the LLC’s debts.[8] Some states have dealt with the issue expressly by statute. For example, California’s LLC statute explicitly makes the common-law principles for piercing the corporate veil applicable to LLCs (except that the failure to hold meetings or observe formalities pertaining to meetings is not a factor in deciding whether to pierce the veil of a limited liability company as opposed to a corporation).[9] But even in those states that have not addressed the question by statute, the courts have held that members of a limited liability company may be held personally liable for its debts under alter ego and other theories for piercing the corporate veil.[10]

While piercing is available in cases involving a limited liability company, “[t]he cases indicate that courts are as unlikely to pierce in LLC settings as they are in corporation settings.”[11] Thus, members of a limited liability company may gain a very small measure of extra protection in states, like California, holding that certain factors relevant to piercing the veil of a corporation do not apply in the context of an LLC. But the added protection is so miniscule, and it is so difficult to justify piercing the veil of either type of entity anyway, that that consideration should not, in and of itself, decide whether to organize a business as a corporation or as a limited liability company.

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[1]See, e.g., Bonacasa Realty Co. v. Salvatore, 109 A.D.3d 946, 947, 972 N.Y.S.2d 84, 85 (2d Dep’t 2013) (“One of the primary legitimate purposes of incorporating is to limit or eliminate the personal liability of corporate principals.” (internal quotation marks omitted)). See generally 1 Larry E. Ribstein & Robert R. Keatinge, Ribstein and Keatinge on Limited Liability Companies § 1:5 (Westlaw database updated Dec. 2015) (“A principal motivation for the creation of LLCs was the desire to eliminate the owners’ vicarious liability for the obligations of the LLC.”); 1 Fletcher Cyclopedia of the Law of Corporations § 14 (Westlaw database updated Sept. 2015) (“[A] corporation may properly be organized and conducted for the avowed purpose of maintaining it as a separate entity free from shareholder responsibility for the corporation’s debts.”).

[2]Michaels v. Banks, 959 F. Supp. 2d 244, 245 (N.D.N.Y. 2013).

[3]AZTE, Inc. v. Auto Collection, Inc., 124 A.D.3d 811, 812, 2 N.Y.S.3d 212, 214 (2d Dep’t 2015).

[4]Borough of Manhattan Cmty. Bd. 7 v. Schaffer, 84 N.Y.2d 148, 155, 639 N.E.2d 1, 4 (1994).

[5]N.Y. Ltd. Liab. Co. Law § 609(a); see also Cal. Corp. Code § 17703.04(a) (“[T]he . . . debts, obligations, or other liabilities of a limited liability company, whether arising in contract, tort, or otherwise[,] . . . are solely the debts, obligations, or other liabilities of the limited liability company to which the debts, obligations, or other liabilities relate[, and] . . . do not become the debts, obligations, or other liabilities of a member or manager solely by reason of the member acting as a member or manager acting as a manager for the limited liability company.”).

[6]See, e.g., Wyatt v. Union Mortg. Co., 24 Cal. 3d 773, 785, 598 P.2d 45, 52 (1979) (“Shareholders of a corporation are not normally liable for its torts, but personal liability may attach to them . . . when the shareholder specifically directed or authorized the wrongful acts.”); Savannah T & T Co. v. Force One Express Inc., 58 A.D.3d 409, 409, 872 N.Y.S.2d 83, 84 (1st Dep’t 2009) (corporate defendant’s principal was properly held personally liable for his own wrongful conduct, regardless of whether the corporate veil was pierced); Cal. Corp. Code § 17703.04(c) (“Nothing in this section shall be construed to affect the liability of a member of a limited liability company to third parties for the member’s participation in tortious conduct[.]”).

[7]See, e.g., Associated Vendors, Inc. v. Oakland Meat Co., 210 Cal. App. 2d 825, 26 Cal. Rptr. 806 (1st Dist. 1962). The test used to decide whether to pierce a corporation’s veil in a particular case is described in “Understanding How Courts Pierce the Corporate Veil” and other articles on this website.

[8]See, e.g., Byron F. Egan, Choice of Entity Decision Tree After Margin Tax and Texas Business Organizations Code, 42 Tex. J. Bus. L. 71, 173 (2007) (“Because the [Texas] LLC Act deals expressly with the liability of Members and Managers for LLC obligations, the principles of ‘piercing the corporate veil’ should not apply to LLCs in Texas, although this issue is not settled.”).

[9]See Cal. Corp. Code § 17703.04(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.”); cf. United States v. Healthwin-Midtown Convalescent Hosp. & Rehab. Ctr., Inc., 511 F. Supp. 416, 418-19 (C.D. Cal. 1981) (among the factors considered in determining whether the corporate veil should be pierced are the failure to observe corporate formalities and the absence of regular meetings), aff’d, 685 F.2d 448 (9th Cir. 1982). Even without language in an LLC statute specifically referring to the factor of observing formalities, it has been suggested that “[d]isregard of corporate formalities is a factor that will play a much smaller role in LLC piercing cases [because u]nlike corporations, which require numerous corporate formalities such as holding shareholder meetings and issuing annual reports, LLCs are constrained by very few formalities and thus are less likely to be tripped up by this requirement.” Karin Schwindt, Limited Liability Companies: Issues in Member Liability, 44 UCLA L. Rev. 1541, 1561 (1997).

[10]See, e.g., Baker, Sanders, Barshay, Grossman, Fass, Muhlstock & Neuworth, LLC v. Comprehensive Mental Assessment & Med. Care, P.C., 110 A.D.3d 1022, 1023-24, 974 N.Y.S.2d 93, 95 (2d Dep’t 2013) (allegations that individual dominated the LLC and engaged in acts amounting to an abuse of the privilege of doing business in that form so as to perpetrate a wrong or injustice were sufficient to state a cause of action against the individual under the theory of piercing the corporate veil). See generally J. William Callison & Maureen A. Sullivan, Limited Liability Companies: A State-by-State Guide to Law And Practice § 5:3 (Westlaw database updated July 2015) (“Despite the general provisions in the LLC statutes that members are not personally liable for the LLC’s debts, obligations, or liabilities, LLC creditors and other third parties to whom an LLC is liable will likely be able to apply a theory of member liability similar to the common law piercing the corporate veil concept, in appropriate circumstances.” (collecting numerous cases analyzing the issue)).

[11]Callison & Sullivan, supra note 10, § 5:3.