Just what IS a limited liability company? Part 5. It has a liability shield.

[This is the fifth post in a seven-part series discussing the characteristics of limited liability companies and comparing them to the characteristics of corporations, general partnerships, and sole proprietorships. Here’s the entire list.

Part 1. Background on sole proprietorships.
Part 2. Background on partnerships.
Part 3. Background on corporations.
Part 4. LLCs are distinct legal entities, separate from their owners.
Part 5. A limited liability company’s owners are not liable for the LLC’s obligations.
Part 6. Options for an LLC’s management structure.
Part 7. Options for an LLC’s tax treatment.]

Thumbnail image for iStock_000006322570XSmall.jpgThe last entry in this series explained that a limited liability company has its own legal identity, separate from its members. A related concept is that a limited liability company has a liability shield, sometimes called a corporate veil, between itself and its members. That means that the members of a limited liability company are not liable for the debts or obligations of the LLC itself, just as the shareholders of a corporation are not liable for the debts or obligations of the corporation itself.

To see how that works, let’s imagine that you and two of your good friends, Jack and Jill, decide to buy a bicycle shop. You consult an attorney, and he recommends that you create a limited liability company to buy the shop. He writes an operating agreement for you, which all three of you sign, files articles of organization in the Indiana Secretary of State‘s office, and takes care of other details such as obtaining an Employer Identification Number . At that point you are the proud owners of a limited liability company Three Good Friends, LLC . (By the way, there is no such LLC in Indiana. I know that because I ran a search on the Secretary of State’s website.) The purpose of the LLC is to buy and run a bicycle shop. To raise the money, you and Jill each drain your savings accounts, and Jack mortgages his house to the hilt. All three of you put the money (called your initial capital contributions) into the LLC, and with that money the LLC buys a bicycle shop, which you rename as Three Good Friends Bicycle Emporium. The LLC’s lawyer files a certificate of assumed business name showing that Three Good Friends, LLC is now doing business as Three Good Friends Bicycle Emporium.

While you’re working in the shop one afternoon, a delivery truck arrives. A LARGE delivery truck. The driver comes in and asks where you’d like to put the 700 bicycles you ordered. (I don’t know if a single truck can actually hold 700 bicycles, but cut me some slack and go with me on this.) You tell him there must be some mistake because you ordered only 7 bicycles. After a frantic search through your computer files, you realize that a mistake was indeed made — and that you’re the one who made it. You really did order 700 bicycles. And they’re expensive bicycles. VERY expensive. You make a few phone calls and find out that the bicycles cannot be returned and that the shop will have to pay for them. You also know that there’s not nearly enough money in the LLC’s bank account to pay for the bicycles.

You tell Jack and Jill what happened, expecting them to be furious — and Jack is. As Jack often does, he imagines the worst. He says that the bicycle manufacturer is going to sue not only the shop but all three of you. He worries that not only will the three of you lose the business, but that he’ll lose his house, which he mortgaged to the hilt to come up with the money for the business. Jill, being her characteristically calm self, tells Jack not to worry. The reason that they set up a limited liability company was so that none of the three good friends can be held liable for the debts of Three Good Friends Bicycle Emporium. She tells Jack that even if the LLC goes bankrupt, his house is safe from the bicycle manufacturer. Is Jill right?

Yes, she is. The bicycle manufacturer cannot make the three of you, as individuals, pay for the 700 bicycles. The purchase order was issued in the name of the LLC, not in the names of the members. The bicycle manufacturer can sue the LLC and, if it wins, it can reach the LLC’s bank account, as well as the shop’s inventory, accounts receivable, and other assets. But the bicycle manufacturer cannot get to the members’ personal bank accounts, houses, cars, etc. because the members are protected by the LLC’s liability shield, or corporate veil. (At least that’s ordinarily the case. In relatively unusual circumstances, the LLC’s creditors can indeed reach the assets of the members, which is called “piercing the corporate veil.” That’s the subject of later entries on this blog.)

Note, however, that Jack may still have reason to worry. Although his house is not directly at risk, all the money that he put into the LLC — as well as all the money that you and Jill put into the LLC — IS at risk. And recall that Jack raised his share of the money by mortgaging his house. If the LLC goes out of business, and if Jack doesn’t find some other source of income to make his house payments, he may still lose his house — but to the bank, not to the bicycle manufacturer.

If you’d like to discuss whether a limited liability company is the right choice for your business, you may contact our firm for an initial consultation.