“Respect the Structure” by John M. Carnahan III
Over the years we have written several articles about the legal theory of “Piercing the Veil”, which basically is a theory wherein a creditor attempts to set aside the legal structure of an entity chosen by the owners and go after the assets of the owners individually. There are several factual patterns which lend themselves to the ability of a creditor to use that theory in order to collect the amount owed against the owners, rather than the otherwise bankrupted judgment proof entity. Usually there is a situation where the structure of the entity has been ignored and the entity was set up with the intention of defrauding creditors, or where the entity operated in a manner that those doing business with it, for reasonable cause believed they were doing business with another business or entity.
A recent decision of the Federal First Circuit Court of Appeals involving a Massachusetts Limited Liability Company serves as a reminder that if you want the benefits of the legal structure you have chosen for your business activities, you need to respect that entity and follow some fairly straight forward rules regarding operations. It was the inverse of the normal factual pattern, and the court held that a creditor of the owner had priority over a creditor of the LLC entity which owed the money.
Mr. Livermore owned approximately fifteen acres of undeveloped land in Ludlow, Massachusetts and decided to develop the property into eleven lots. He formed a Massachusetts Limited Liability Company, transferred the property into that entity, borrowed development money from a local bank secured by a mortgage and started the process. Unfortunately the sale of the properties was not as successful as planned and Mr. Livermore defaulted on the loan and the bank foreclosed. At the same time, for the tax years 2006, 2007 and 2008, Mr. Livermore incurred personal unpaid federal tax liabilities arising from the income from the sale of lots which he reported on his individual income tax return, in that apparently it was in what is known as a “single member LLC”, also known as a disregarded entity. The Internal Revenue Service recorded a Notice of Federal Lien against Mr. Livermore in regards to these liabilities.
After the bank foreclosed, there was approximately $92,000 of surplus funds, which was interpleaded into a court account. The City of Ludlow was owed a substantial amount of money in that it was required to step in and complete the public improvements for Mr. Livermore’s development (i.e., streets, sewers, sidewalks), and therefore obtained a judgment against the LLC for the funds. Unfortunately the IRS smelled money, and sought to enforce its lien against the individual owner against the assets of the LLC. While Mr. Livermore did follow certain formalities, such as transferring ownership of the real estate into the entity, filing the required reports with the state and he kept records of its business transactions, and even maintained a minute book, unfortunately, the United States District Court and the Federal Court of Appeals, both relied on the fact that Mr. Livermore comingled the funds of the LLC with his personal account, and that the LLC entity did not maintain a separate bank account. Therefore, utilizing a variation of the theory of Piercing the Veil, known as the “nominee” theory, the Court held that the owner’s IRS Tax Lien took priority and would receive the court escrowed funds belonging to the LLC.
This is just another example of the importance of following the rules of the road. If you are going to use a limited liability company to get the benefits of protection against liability, you need to make sure that you respect the entity. For example, if it sells assets or receives income the funds need to be clearly deposited in an account in its name and it needs to maintain its own insurance policy and hold itself out as a separate entity. If you were using an LLC to own a rental property, you would want the deed in the name of the LLC, the leases in the name of the LLC and signed by an authorized representative of the LCC, the deposit and rent checks deposited in the name of the LLC and the expenses of the rental property paid by the LLC. If there were insufficient funds in the account to pay the bills and you intended to pay them, then the owner (or the technically correct term “member”) would deposit the money in as a contribution to the capital, or in some cases a loan, or even a secured loan if concerned about collectability, and then the LLC’s account would have the funds necessary to pay its bills.
Maintaining appropriate minutes to reflect the fact that loans are approved, establishing the bank account and authority to enter into agreements and contracts is also another important aspect of respecting the choice of entity and enjoy the benefit of it, including limited liability.