Case Study: Piercing the LLC Liability Shield

Posted on November 6, 2013 by

Sally and Julie grew up together and have decided to invest in real estate. They both have regular jobs, but figure they can find a property, fix it up and rent it out in their spare time. They find a good property which takes most of their savings as a down payment. They figure that over the next few months, they can get the repairs done with money earned on their regular jobs.

They decide that with contractors on the property and tenants once it is fixed, they need to have a liability shield to protect them personally. They set up a Limited Liability Company and purchase the house in it.

Sally and Julie are so excited and anxious to get the rehab done that they neglect to have an organizational meeting nor do they have any subsequent meetings. They figure it is no big deal since they are close friends and talk every day anyway. They also want to save money and decide not to set up a bank account for the LLC. Julie agrees to use her account to run all the expenses through with Sally putting in half the costs. Julie then agrees to put the utilities in her name.

They also failed to get a Tax Identification Number (TIN) from the IRS. If they had opened a bank account, they would at least have gotten the TIN since banks would require it. They figured they would just work out the expenses later.

They receive a letter from the state saying they had not paid their annual registration fee nor filed their one page annual report. Because they are in the middle of the rehab, they decide to put this off until a later date. The letter remains at the bottom of their bills pile since the state does not contact them again. On top of all this, they had used their mutual friend Jack as the registered agent. But Jack got a great new job in another state and moved. It did not occur to Sally and Julie that they needed to get another registered agent.

After several months of dealing with contractors, they finally have the property ready for rental. Because of Julie’s schedule, it was agreed that Sally would show the property and sign the lease agreement with the new tenant. Since they do not have an LLC bank account, Sally tells the tenant just to write the check directly to her.

The first couple of months the new tenant is in the house are a relief for Sally and Julie. They now have time to catch up with friends and relax. But they don’t bother to clean up their LLC mess.

Then the tenant is seriously injured falling off a back deck with a faulty railing. They have insurance, but the company refuses the claim since they used unlicensed contractors who did sub-standard work.

Shortly thereafter, both Sally and Julie are served with a lawsuit. They decide they need an attorney to defend them. That is when they find out what “piercing the veil” means. In their state as well as all states, where members conduct their business as if no entity exists or are careless in their dealings such that proper recognition of a separate entity is ignored, liability can attach to each member.

The tenant’s attorney had no problem showing that Sally and Julie did not treat the LLC as a separate entity from themselves and neither should the court. Some of the evidence he put forth to demonstrate this fact was:

  • No organizational meeting or annual meetings (even though most states do not
    require meetings, they are one of the easiest ways to show separateness)
  • A TIN was never obtained from the IRS
  • No bank account was formed to separate company finances
  • Contractor payments made by personal checks
  • No LLC tax returns were ever filed
  • LLC charter revoked by the state for failure to file annual report
  • Resident Agent no longer at registered address and not replaced
  • Rent payment made directly to Sally

Sally and Julie were held personally liable for the tenant’s injuries. Now they have a judgment against them that will last several years or until it is paid off. All their work was lost because of their failure to follow some simple steps that would have protected them from personal judgments.

Make sure you build your liability protection with the bricks of evidence that you treat your entities separately from yourself. You are not the entity and the entity is not you.

Dyches BoddifordDyches Boddiford is a full time investor who speaks from experience in a variety of real estate areas. His seminars and conferences are intended for the serious real estate investor, though entrepreneurs in other businesses or investments will find his training helpful as well.

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