Colorado corporations and LLCs are legal entities, separate from the people who create and own them. One main advantage: as a distinct entity (unlike a general partnership or sole proprietorship), owners and managers have limited personal liability for the company’s debts.
This means that the people who own and run the corporation or LLC cannot usually be held personally responsible for the debts of the business. But under the right/wrong circumstances, courts can ignore the business’s limited liability status and hold its officers, directors, and shareholders or members personally liable for its debts.
An LLC owner (member) of course wants to insulate her assets. There are two related but distinct concepts:
You may have heard the phrase “piercing the corporate veil” (which does not refer to a bride accessorizing her wedding gown with a traditional headdress). Rather, “piercing the corporate veil” refers to circumstances where courts set aside a corporation or LLC’s limited liability protections, and instead hold the owners, shareholders, members or managers personally liable. “Piercing the corporate veil” essentially means penetrating an LLC or corporation’s protective layer.
A “charging order” is a court order relating to money from the LLC that would be paid to a member as a distribution. An LLC member generally earns money from an LLC by receiving distributions of profits. Colorado charging orders put a lien on those distributions, making them payable to the creditor instead of the member.
Too often, business owners mix “business with personal”, which can lead to disastrous outcomes.
Protection Against Personal Liability
Business owners form corporations or LLCs to avoid personal liability for company debts. But sometimes courts will hold an LLC or corporation’s owners, members, and shareholders personally liable for business debts. When this happens it’s called “piercing the corporate veil.”
With COVID-19 we face a challenging economic climate. Many small business owners are scrambling to keep their companies afloat (or are shutting down). If a company closes, the last thing a small business owner wants is to be required to pay the business’s debts.
But when cash is tight and owners aren’t careful when an unpaid creditor sues for payment, a court might “pierce the corporate veil” (lift the corporation or LLC’s veil of limited liability), and hold the owners personally liable for their company’s business debts.
Veil Piercing Applies to Both Corporations and Limited Liability Companies
“Corporate veil” is used interchangeably and applies to both corporations and limited liability companies.
For corporations, Colorado law provides: Unless otherwise provided in the articles of incorporation, a shareholder or a subscriber for shares of a corporation is not personally liable for the acts or debts of the corporation; except that such person may become personally liable by reason of the person’s own acts or conduct (Colorado Revised Statutes § 7-106-203(2)) (emphasis added).
As a general rule, neither members nor managers of an LLC are personally liable for debts incurred by the LLC (Colorado Revised Statutes § 7–80–705). However, Colorado Statutes expressly provide for a notable exception: In any case, in which a party seeks to hold the members of a limited liability company personally responsible for the alleged improper actions of the limited liability company, the court shall apply the case law which interprets the conditions and circumstances under which the corporate veil of a corporation may be pierced under Colorado law (Colorado Revised Statutes § 7–80–107(1)) (emphasis added).
Colorado courts have extended “veil piercing” principles to LLC managers. See Sheffield Services Co. v. Trowbridge, 211 P.3d 714 (Colo. App. 2009); Weinstein v. Colborne Foodbotics, LLC., 302 P.3d 263 (Colo. 2013).
Effects of Piercing the Corporate Veil
Once pierced, creditors can proceed against the owners’ home, bank account, investments, and other assets to satisfy the LLC debt. But courts impose personal liability only on those individuals who are responsible for the corporation or LLC’s wrongful or fraudulent actions; they won’t hold innocent parties personally liable for company debts.
When Will Courts Will Pierce the Corporate Veil?
Courts look at the following factors to pierce the corporate veil and impose personal liability on officers, directors, shareholders, or members:
No real separation between the company and its owners: For example, if the owner pays personal bills from the business checking account, doesn’t keep proper financial records, or ignores the legal formalities that a corporation or LLC must follow (for example, by making important corporate or LLC decisions without recording them in minutes of a meeting), a court could decide that the owner isn’t entitled to the limited liability that the corporate business structure would ordinarily provide.
Wrongful actions, recklessness, or fraud: When an owner recklessly borrows and loses money, made business deals knowing the business couldn’t pay its bills, or otherwise acted dishonestly, a court could find financial fraud was perpetrated and that limited liability protection shouldn’t apply.
Commingled assets: Small business owners are more susceptible to commingle their personal assets with the corporation or LLC’s assets. For example, some small business owners divert corporate assets for their own personal use by writing a check from the company account to make a payment on a personal mortgage — or by depositing into the owner’s personal bank account a check made payable to the LLC. This is called “commingling assets.” To avoid trouble, the LLC should maintain its own bank account, and the LLC member (owner) should never use the company account for personal use (or deposit into her personal account checks payable).
Undercapitalization: Courts also look at whether a corporation or LLC is undercapitalized. “Undercapitalized” is imprecise, and the definition changes depending on the business. This is clear: never purposely keep your company in a state where it lacks assets needed to pay creditors. Make a reasonable initial investment in the company, so that you have a fair share of the risks. And document everything (which is what we at 180 Law Co. do!).
Corporate identity not preserved: Business owners must let the world know they are dealing with a corporation or LLC. The simple way to accomplish that: conspicuously identify the company status (e.g., “Inc.” or “LLC”) on all business cards, letters, quotes, invoices, statements, directory listings, advertisements, and all other forms of company communication. When signing company documents (including emails!), clearly state your title/representative capacity, such as, “Sally Smith, CEO, XXX, LLC”.
Helpful Hint Regarding Electronic Communications
Important Note: with the informalities of electronic communications (especially text messages), it’s too easy to blur the corporate/individual distinction. Although you may assume you’re conversing on the company’s behalf, the other party might understand differently. At 180 Law Co., we recommend using a standard signature line, for both emails and texts. We can help you set that up, to seamlessly use a standard signature on all your business communications.
Colorado Charging Orders
Even when the LLC’s “corporate veil” isn’t pierced, a member LLC’s interest can be attached by a “charging order”.
Let’s use easy examples:
Mary Jones goes on a $10,000 spending spree, using her personal credit card for non-business items(e.g., clothes or household appliances). If Mary used the LLC’s company credit card for personal expenses, then “corporate veil piercing” principles might apply. This is fundamentally different: she uses her personal credit card.
Susan Smith borrows $20,000 from a Denver bank for a home improvement loan, to remodel her kitchen and build a deck.
If the member won’t or can’t repay these legitimate personal debts, the creditor can go to court to force the member to pay.
In all states, personal creditors can not only go after a debtor’s personal assets (such as garnishing wages from paychecks), but also obtain rights to a debtor’s LLC membership interests. That is known as a “charging order”
State laws differ. Some states limit charging orders to company distributions only. Other states go further, and allow the creditor to “step into” the member’s interests, and have broader ownership rights. At 180 Law Co., we’ll guide you through this maze.
Starting a New Business? Does Your Business Need a Checkup?
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