A primary reason for forming an LLC is to protect a client’s other assets from liabilities arising from the business of the LLC.  That protection may now be at risk.

For some time, practitioners have been alert to the limitations in some states of the protection afforded to assets held in a SMLLC even when the statute, as in Arizona, provided a charging order as the sole and exclusive remedy, but now there is a new concern – that even clients that meet state law may be at risk under alter ego liability theories.

I’m taking a break this week from the explanations of basic estate planning to discuss an important recent case which imposes troublesome limitations on the protection afforded by a single member LLC.

The Colorado appellate court recently used an alter ego analysis to erode the protection an LLC provides to its members.  In Martin v. Freeman, the court employed a 3 prong analysis and found that a single member of an LLC was liable for the debts of his LLC because (1) the LLC was the alter ego of its member, (2) that the entity was used to defeat a rightful claim, and (3) an equitable result was obtained by ignoring the entity.  The court considered a variety of fact specific elements, including insider control, thin capitalization, the entity was a mere shell, legal formalities were disregarded, and commingling of funds, all relatively common occurrences in the operation of Arizona LLCs.  The court’s analysis twisted relative innocent facts to reach the conclusion that the validly formed and operated LLC provided no protection for its single member.  There was a spirited dissent which drew a bright line on the lengths to which the majority was willing to go to express its dislike for the notion that clients can avoid potential liability by merely forming an LLC in compliance with existing statutes.

The case makes clear that clients must supply something much more than a shell of an LLC.  Observation of certain elements derived from sometimes obtuse rulings from other jurisdictions may be important in cementing the client’s protection.  Merely observing the letter of the statute may not be enough.

Call me for a copy of my newly revised LLC operations manual which describes additional steps which may be important if you are to avoid personal liability when your LLC is sued, to obtain a more robust operating agreement, or form a new LLC.  Be careful out there, it is a dangerous world.