The most common question I get from business owners is this: why does my single-person LLC need an operating agreement, and how can I protect my business?
If you’re a “solopreneur” with an LLC, chances are it’s because you’ve heard some sort of variation of this scenario: LLCs provide liability protection. If your LLC ever gets sued and a judgment is rendered against you, the judge could pull from your personal accounts, even make you sell your house and your car, in order to pay the judgment, etc etc.
I don’t mean to demean that scenario, but I know it’s never fun to talk about the scary side of business. However, sometimes it’s quite literally my job to do that: I want to help you identify the potential landmines so that you know how to run your business as smoothly and safely as possible. With that in mind, I want to educate you on what is probably the most common issue I see with creative business owners and the most common question I field in general. What does a “solopreneur” need to do to protect their LLC, and why would a single-person LLC ever need an operating agreement?
In American law, corporations and LLCs are technically considered entities separate and distinct from the people who found the business. Our legal system basically considers them an “individual” with rights. Why does that matter to you? Members of an LLC cannot be personally held responsible for any of the LLC’s assets and liability while it is a formal entity, but when a judge decides its not in good standing, you lose that protection. Therefore, it’s crucial to know how to keep your LLC in good standing. Entities like “closely held corporations” and small or single-member LLCs are the most susceptible to this scenario.
Also note: for the purposes of today, even though I use the word “corporation”, I’m referring to single-person LLCs as well.
Piercing the Corporate Veil
I’m going to share a little legal lesson with you, and I’m not even joking when I say I had flashbacks cramming for my last final of law school ever, where we were tested over this exact subject in corporate law. Piercing the corporate veil (PCV) is actually a pretty interesting topic in the world of business law, and was one of the first cases I ever had as a practicing attorney.
Anyways, why should you care about all of that?
Well, because as a single person business owner, you run a very high risk of your corporation’s veil getting “pierced”, and losing that valuable liability protection an LLC provides. When that happens, the court considers your LLC an “alter ego” of yourself. This wipes away everything you know about LLC liability protection, leaving you completely on the hook for everything relating to your business. As you know, you forming an LLC builds protective walls around your business, separating your personal assets from your business assets. When a court decides to “pierce” a corporation’s veil, they are “lifting that veil” of limited liability, and the single-person LLC can be held personally liable for the business’s debts. In other words, creditors could go after your home, car, bank account, investments, etc to pay the judgment, and individuals could even be held personally responsible for any fraudulent actions of the LLC.
What factors into PCV?
Before a court will pierce a corporation’s veil, they’ll take a look to see if any of these four scenarios have been met:
(Please note this is not intended to be a complete list of scenarios; just the most common that occur in our industry.)
- There’s no true separation between the company and its owners.
For obvious reasons, this is a big risk that single person LLC’s run. After all, if you’re the only member of your business, how can you prove a separation exists?
The answer is surprisingly simple: make sure you have an operating agreement in place. Not only do you need one “even though” you are the only member of the LLC; you need one especially because you are the only member. The operating agreement will prove that your LLC is governed and runs just like any other business, which of course proves that it truly is a business.
2. Commingling funds.
This is why you’ll hear attorneys, accountants, and financial people harp on having a separate business bank account so much. “Commingling assets” can occur when the business owner does something like deposit a check written to your business directly in your personal account or writing a check from your business account to pay off a personal debt, like a car payment or mortgage. This is such an avoidable issue- just open a business bank account, and keep your finances separate. Better yet, hire a CPA and a bookkeeper to help you track your finances, and make sure everything is in line.
3. Failure to maintain corporate formalities.
This is a crucial factor to keep in mind and again can be largely protected by having a single-member LLC operating agreement in place. An operating agreement will state what is required of the LLC each year- such as the number of meetings, admission of new members, distributions of funds, etc. Keep in mind, you can customize your operating agreement to say exactly what you need and can comply with- and by complying with it, you’re maintaining your corporate formalities. If you don’t have an operating agreement, your LLC will be automatically held to your state’s default rules, which you may not even be aware of or be able to comply with.
How can a single person LLC protect themselves from PCV?
Now that I’ve spent enough time talking about the scary side of the law, I want to talk about the simple ways that you can protect yourself. You probably already know what the answer is, but protecting your LLC from PCV generally requires keeping one thought in mind: establish your business as a separate entity. How? First, open a business bank account. Second, make sure your LLC has an operating agreement. It’s truly that simple.
In an effort to avoid PCV scenarios, many banks will conveniently require that you provide your LLC’s operating agreement when you open up your bank account. The operating agreement acts as the cornerstone in proving that your LLC is a separate entity, upon which all other factors are built. As I mentioned, this operating agreement does not need to be an extensive, wordy document. It simply should cover what I would call the essentials of your business: all of the information from your articles of organization, as well as the name of the member, how much capital you’re initially investing into your business, how debts and assets will be distributed, how new members can be added, etc. You can find a template for a single-member LLC operating agreement here that you can start using today.
In addition to the simple steps listed above, keep these factors in mind to help protect yourself from PCV:
- Don’t commingle your funds- decide now that you won’t use your business funds for personal use without first cutting yourself a paycheck.
- Make an initial investment into the LLC when you’re opening up your account.
- Follow all of the rules listed in your operating agreement.
- Don’t sign as a personal guarantor of any of your LLC’s debts.
- Make sure you’re signing all of your contracts properly
- Be conspicuous about the fact your LLC is an LLC- put it on your website, your contracts, invoices, etc.
- Finally, don’t engage in any fraudulent or illegal acts with your LLC (duh, right?)