"LAYERING" LIMITED LIABILITY COMPANIES: DOES IT ENHANCE THE LIABILITY SHIELD?

Over the years many business owners, intending to enhance their companies' liability shield, have created layers of corporations or limited liability companies (LLCs). Sometimes "safe" assets (those that create minimal risk exposure) are held in one entity, and "dangerous" assets are kept in separate entities - often ones with no other assets - with all entities under common ownership. Sometimes, for the same reasons, individuals create "umbrella" entities that own one or more subsidiary operating entities. These actions can result in multiple formation fees, increased administrative work, and the additional expense of multiple tax returns. But does "layering" really enhance the entities' liability shield?

The Rise of LLCs
Until 1977 corporations were generally the favored form of business entity, offering desirable features like limited liability for owners, centralized management, and potentially unlimited duration. Since 1977 though, when Wyoming introduced the United States' first LLC statute, LLCs have risen in popularity. LLCs are appealing in part because they can combine the desirable features of corporations with the best elements of a partnership: flexibility and pass-through tax status.

Oregon's first LLC statute, the "Oregon Limited Liability Company Act," became effective on January 1, 1994. Much has been written over the years regarding the tax, management, and liability shield benefits of LLCs. Some commentators have concluded that there is no other form of entity that is as easy to form and maintain, and that provides as much structural flexibility, while still protecting members and managers from entity obligations.

In spite of the multiple benefits of LLCs, business owners still face dilemmas, such as: how to combine diverse assets into a single entity without exposing "safe" assets to the liabilities of "dangerous" assets; and how to avoid entity creditors' efforts to pierce the LLC's liability shield to recover from its owner(s) on claims relating to entity liabilities.

Series LLC Laws
Some states, such as Delaware, Michigan, and Nevada, have legislatively recognized "series" LLCs, allowing multiple separate LLCs to operate as an individual entity under one original LLC. These "series" LLCs pay just one filing fee, and (theoretically) file just one income tax return each year. Under the series statutes, each properly formed series LLC, as well as the original LLC's assets, are insulated from the liabilities of the others in the series. However, since Oregon's Limited Liability Company Act does not recognize series LLCs, this type of "layering" for liability planning purposes is not readily available in Oregon.

While some non-series LLC states may allow series LLCs from other states to register (or qualify) do business within their borders, Oregon does not. As a result, Oregon business owners are still faced with the question of whether the additional cost and administration of creating and maintaining layers of LLCs actually enhances their ability to shield other entity or personal assets from entity liabilities.

"Piercing" an LLC's Liability Shield
As is the case with corporations, the liability shield of LLCs is not all-encompassing. Instead the shield has gaps and limitations, which usually arise from one (or more) of four major types of problems: (1) defects in formation; (2) wrongful conduct by a member; (3) abuse of the shield; or (4) capital-related requirements under the LLC laws. Since LLC statutes in general are relatively new, the analysis of whether entity creditors can pierce an LLC's liability shield is generally determined under corporate law.

Wrongful shareholder conduct, such as the shareholders' improper control of a corporation, may allow creditors to "pierce the corporate veil." In a 1982 ruling, the Oregon Supreme Court concluded that a creditor seeking to collect a corporate debt from a shareholder on this basis must prove that: (a) the corporation was under the actual control of the shareholder; (b) the creditor's inability to collect from the corporation was due to improper conduct by the shareholder; and (c) the shareholder's exercise of control actually induced the creditor to enter the transaction with the corporation (or caused the corporation's default on the obligation). The courts have identified three primary examples of "improper" shareholder conduct: (1) inadequate capitalization (corporations must maintain sufficient capital to cover their reasonably anticipated liabilities); (2) milking of assets (for example, payment of excessive dividends, selling products to shareholders at a reduced price, or exacting unreasonable management charges); and (3) violation of statute (such as parent corporations which do business via wholly-owned subsidiaries solely to evade federal or state regulations).

Wrongful conduct by LLC members will likely have the same result. Recently, a federal court in Minnesota permitted an LLC creditor to pierce the LLC's liability shield and reach the corporate parent owner under the "alter-ego" theory. Under the alter-ego theory, where the sole owner of a limited liability subsidiary company controls all the decisions of that subsidiary, the subsidiary will be viewed as the alter ego of the parent. In a similar Ohio ruling, the court held a single owner/manager of an LLC personally liable for environmental fines levied against the LLC. Consistent with these cases, most alter-ego rulings involve entities with a single member/ shareholder (or very few members/shareholders) who exercise control over the entity.

When single or few members/shareholders are involved, creditors seeking to pierce the liability shield often seize the opportunity to sue the entity's members/shareholders (in addition to the entity), regardless of whether the entity is financially able to respond to the claim on its own. The creditor often feels that suing the members/shareholders improves their negotiating position with little, if any, adverse consequences. As a result, the members/shareholders are forced incur unanticipated defense costs, even after devoting significant resources to establishing layers of entities for protection against entity creditors.

Layering is No Guarantee
In Oregon, while there are certainly considerable justifications for separating "safe" assets and "dangerous" assets into separate entities to manage exposure, there is less justification for incurring the expenses of creating multiple layers of LLCs simply to insulate the LLCs' owners from entity creditor claims. Layers of LLCs do not enhance the protection of the statutory liability shield, especially given that Oregon does not recognize series LLCs.

It is important to keep in mind that in Oregon, an individual's sole ownership of an LLC is not, standing alone, sufficient basis to pierce the liability shield that LLC members normally enjoy. Proper entity formation, capitalization, and management appear to be the best policies for preserving the liability shield. Creating and maintaining layers of LLCs dominated by a common person or entity does not strengthen the liability shield for the LLC's owners, nor does it close statutory gaps in the liability shield protection, especially where the LLC has single or few owners.

Dunn Carney's Closely Held Business Team
As stated above, there are still a number of instances in which multiple entities can make good sense for business owners. With the appropriate structure, separating "safe" assets and "dangerous" assets into separate entities to manage exposure is still a valid strategy. This article simply states that creating multiple layers of LLCs solely for the purpose of insulating the ultimate owner from entity creditor claims does not appear to result in greater owner protection from the claims of entity creditors. If you would like assistance with structuring your business entity ownership, please contact Randall L. Duncan, Chair of our Closely Held Business Team, or David J. Buono, a partner and member of the Closely Held Business Team. We will be happy to accommodate your request.

Closely Held
Business Team

The Closely Held Business Team - Dunn Carney is dedicated to assisting business owners in navigating through the opportunities and challenges the law presents to advance each owner’s success in business. They understand the multifaceted issues business owners face each day and the need for responsive and proactive legal counsel.

Team members include:
Randy Duncan, Team leader
Bob Allen
Ric Ashe
John Barhoum
Merrill Baumann
David Buono
Brian Cable
Jack Cooper
Ken Davis
Tim Hering
Frank Hilton
Elizabeth Howard
Scott Jonsson
Robert Kerr
JoDee Keegan
Kelly Martin
David Rossmiller
Eric Smith
Kyle Stinchfield
Dan Vidas
Matt Wilmot
Bob Winger
David Zehntbauer