Hello everybody. From time to time, AOA members vest title to their apartment building in the name of a corporation in which they are the sole shareholders or in the name of their limited liability company in which they are the sole members. Typically that is done for two reasons: (1) asset protection and (2) estate planning and associated tax benefits. My discussion this month will focus on asset protection (and the lack thereof), leaving taxation and estate planning issues for another day.
The goal of asset protection is to protect the individual owners from personal liability in the event that a judgment is awarded in connection with their property, such as in favor of a tenant or injured third party. For example, if compensatory damages are entered by the Court in favor of a tenant who was assaulted due to the failure of a corporate or LLC landlord to provide reasonable security, only the assets of the corporation or LLC (typically the apartment building and its bank account will be the only significant assets), and not the individual shareholders or members, will be liable for the damages.
The theory is that since corporations and LLCs are legal entities which have their own separate existence from that of their principals, a debt of the entity (such as a jury verdict) should not become the debt of the owners. But there are two important exceptions, or at least qualifications, to that concept. Accordingly, owners who contemplate forming a corporation or LLC for purposes of insulating themselves from personal liability to a tenant or to a guest or business invitee of the apartment complex should bear in mind the following.
INDIVIDUAL LIABILITY
While individual shareholders or members of an entity are not liable for its debts merely because they own the corporation or LLC, the individual persons who are personally responsible for managing and maintaining the building (which are often the owners themselves) are personally liable for their own negligence independently of the liability of the entity. As an example, if the individual shareholder or member actively manages the building but fails to implement resasonable measures to prevent the recurrence of foreseeable violent assaults on his property (such as by improving lighting, repairing broken locks, hiring a security guard, increasing the height of exterior walls, or other steps as may be reasonably prudent to eschew a likely repeat of violent conduct), that individual, in addition to the corporation or LLC itself, will be personally liable to the injured party.
That is to say, the individual is not liable because he owned the stock of the corporation or had membership interest in the LLC, but because he negligently operated the building.
PIERCING THE VEIL
Occasionally, shareholders or members of the entity are held personally liable merely because of their ownership status based on the legal theory of piercing the corporate or LLC veil. The doctrine is known as “Alter Ego.”
Historically, we humans have gone to great lengths to shield ourselves from harm. In merry Old England, landowners protected themselves with the aid of their knights, and the knights were clothed in suits of armor to protect their own selves from the swords of their assailants.
In today’s civilized world, the weaponry is often litigation with a piercing of the shield being the judgment of the court. As discussed previously, in order to protect against such judgments, owners frequently form a corporation or LLC, and raise it as a shield against the plaintiff’s accusations.
If an individual shareholder or member was not responsible for preventing the injury (such as in cases where all aspects of the security of the building were handled by the entity’s employee or an outside management company acting on behalf of the legal entity, and the owner had no notice of or participation in the lack of security), that shareholder or member would not be personally liable to the plaintiff. Any judgment, would be awarded, at worst, against the corporation or LLC (as well as the negligent employee or management company).
In the instructive case of Baize v. Eastridge Companies, 142 C.A.4th 293, the California Court of Appeal explained that a corporation’s separate nature as an independent entity may be disregarded under the Alter Ego doctrine and its corporate veil pierced when two general conditions are met: (1) That there is such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist, and (2) that if the acts were treated as those of the corporation alone, an inequitable result will follow.
The court cautioned that “since the separate personality of the corporation is a statutory privilege, it must be used for legitimate business purposes and must not be perverted.” The court held that when “the separateness of the corporation is abused, it will be disregarded and the corporation looked at as a collection or association of individuals, so that the corporation will be liable for the acts of the stockholders or the stockholders will be liable for acts done in the name of the corporation.”
Situations which shareholders or members of LLCs should avoid in order to best preserve the corporate or limited liability company protection follow. The more of these items that exist, the more likely it is that a court will find that the corporate or LLC shield should be pierced and the underlying owners held personally liable:
- Money and assets of the individual owners are commingled with those of the entity.
- The owners fail to segregate their own funds from those of the entity.
- The owners’ failure to adequately capitalize the entity when it is formed such that the entity may not be able to meet its anticipated debts. Note: The advice of a good accountant is often helpful to determine the adequacy of capitalization.
- In the case of a corporation, it fails to issue stock to the individuals.
- The corporation fails to hold annual meetings of the Shareholders and Board of Directors and fails to maintain corporate records and minutes.
- The individual owners hold themselves out as being personally liable for the debts of the entity, such as when they contract with a roofer in their own names for the construction of a new roof, or they lease a laundry room in their own names to a laundry company, rather than in the name of their entity.
- The entity is used as a mere shell or instrumentality for a single venture or business of the individual.
- The entity disregards various legal formalities and fails to maintain an arms-length relationship among related entities or individuals.
- There exists a diversion or manipulation of assets from the entity to an owner or other person to the detriment of creditors.
- The entity is formed with the intent to avoid performance by the entity or the entity is formed for purposes of carrying on illegal transactions.
- The owner withdraws rents deposited into the entity’s account without regard to the fact that the rents belong to the entity, rather than to the individual.
- The owner frequently deposits his own funds into the corporation’s or LLC’s bank account so as to render the entity financially solvent to pay its debts.
- The owner uses a single address for the individual and the entity.
Because the doctrine of Alter Ego is based on principles of equity, the court will evaluate each case separately to ascertain which, if any, of the above elements exist, and whether, because of the apparent unity of interest and ownership between the entity and the owners, an inequitable result would occur if the entity’s shield is not pierced.
CONCLUDING REMARKS
As can be seen, the use of a corporation or LLC to hold title to multifamily residential properties is not necessarily the panacea of protection that the principals of the entity may expect. For AOA members who form a corporation or LLC to acquire or hold title to their buildings, I encourage you to carefully consider the 13 items set forth above so as to enhance the probability that your corporation’s or LLC’s legal separation will be preserved.
Also, one of the best protections for the underlying owners of the entities to avoid personal liability, not only of themselves but also the liability of their companies, is to engage an independent management company to operate the property. By so doing, the owners distance their entity as well as themselves from personal management, and in turn, from liability due to any negligent operation of the building.
Dale Alberstone is a prominent litigation and transactional real estate attorney who has specialized in real property law for the past 36 years. He has been appointed to periodically serve as a judge pro tem of the Los Angeles Superior Court and is a former arbitrator for the American Arbitration Association. He also testifies as an expert witness for and against other attorneys who have been accused of legal malpractice.
Mr. Alberstone has been awarded an AV rating from Martindale-Hubbell. An AV rating reflects an attorney who has reached the heights of professional excellence and is recognized for the highest levels of skill and integrity. You may Google “Dale S. Alberstone” for further background.
The foregoing article was authored on June 3, 2013. It is intended as a general overview of the law and may not apply to the reader’s particular case. Readers are cautioned to consult an advisor of their own selection with respect to any particular situation.
Address correspondence to Dale S. Alberstone, Esq., ALBERSTONE & ALBERSTONE, 1801 Avenue of the Stars, Suite 600, Los Angeles, California 90067. Phone: (310) 277-7300.