This article addresses “piercing the veil,” which refers to the limited circumstances under which the liability shield of a registered legal entity (an LLC or corporation) may be pierced and the individuals behind that entity held personally accountable. Knowing when this might or might not occur is an important factor in asset protection since a piercing event defeats the central purpose of forming an entity in the first place.
Piercing the veil is an equitable remedy that is available only in exceptional circumstances. Wilson v. Davis, 305 S.W.3d 57, 59, 69 (Tex. App.-Houston [1st Dist.] 2009, no pet.). Section 101.114 of the Business Organizations Code (“BOC”) states: “Except as and to the extent the company agreement specifically provides otherwise, a member or manager is not liable for a debt, obligation, or liability of a limited liability company, including a debt, obligation, or liability under a judgment, decree, or order of a court.”
Nationally, most states allow some sort of veil-piercing. Texas is an exception with its “actual fraud rule.”
The Actual Fraud Rule
Historically, Texas law permitted piercing the corporate veil when “(1) the corporation is the alter ego of its owners and/or shareholders; (2) the corporation is used for illegal purposes; [or] (3) the corporation is used as a sham to perpetrate a fraud.” Rimade Ltd. v. Hubbard Enterprises, 388 F.3d 138 (5th Cir. 2004). However, these traditional piercing standards were cast aside in 2006 when the legislature enacted BOC Section 101.114 (quoted above) which significantly narrowed legitimate avenues for piercing. Section 21.223 further defines and limits the exposure of shareholders and members:
§ 21.223. Limitation of Liability for Obligations
(a) A holder of shares, an owner of any beneficial interest in shares, or a subscriber for shares whose subscription has been accepted, or any affiliate of such a holder, owner, or subscriber of the corporation, may not be held liable to the corporation or its obligees with respect to:
(1) the shares, other than the obligation to pay to the corporation the full amount of consideration, fixed in compliance with sections 21.157-21.162, for which the shares were or are to be issued;
(2) any contractual obligation of the corporation or any matter relating to or arising from the obligation on the basis that the holder, beneficial owner, subscriber, or affiliate is or was the alter ego of the corporation or on the basis of actual or constructive fraud, a sham to perpetrate a fraud, or other similar theory [italics added]; or
(3) any obligation of the corporation on the basis of the failure of the corporation to observe any corporate formality, including the failure to:
(A) comply with this code or the articles of incorporation or bylaws of the corporation; or
(B) observe any requirement prescribed by this code or the articles of incorporation or bylaws of the corporation for acts to be taken by the corporation or its directors or shareholders.
(b) Subsection (a)(2) does not prevent or limit the liability of a holder, beneficial owner, subscriber, or affiliate if the obligee demonstrates that the holder, beneficial owner, subscriber, or affiliate caused the corporation to be used for the purpose of perpetrating and did perpetrate an actual fraud on the obligee primarily for the direct personal benefit of the holder, beneficial owner, subscriber, or affiliate.
Actual fraud committed primarily for the direct personal benefit of the corporate shareholder or LLC member is thus required, at least for contract-type claims. Further, to “determine if the [members of an LLC] are liable under the asserted veil-piercing theories, the Court must analyze both the question of whether the facts satisfy any of the asserted veil-piercing strands and the question of whether any of the [members] caused [the LLC] to be used for the purpose of perpetrating and did perpetrate an actual fraud on [the plaintiff] primarily for the direct personal benefit of the considered defendant.” In re JNC Aviation, LLC, 376 B.R. 500, 527 (Bankr. N.D. Tex. 2007), aff’d, 418 B.R. 898 (Bankr. N.D. Tex. 2009). “[The] veil of an LLC may be pierced with respect to the entity’s contractual liability only upon proof that [a member or manager] used the LLC to perpetrate actual fraud for the defendant’s direct personal benefit. Shook v. Walden, 368 S.W.3d 604, 607 (Tex.App.-Austin 2012, pet. denied). Mere allegations of “alter ego” or “sham company” are insufficient. Metroplex Mailing Servs. v. RR Donnelley & Sons Co., 410 S.W.3d 889 (Tex.App.-Dallas 2013, no pet.).
Accordingly, allegations by the plaintiff that the defendant company is a sham without substance or is operated as the alter ego of its owners-both of which appear regularly in Texas pleadings-are insufficient as a matter of law when standing alone to achieve a piercing. Actual fraud is required. Texas courts recognize the “strict restrictions on a contract claimant’s ability to pierce the corporate veil.” Ocram, Inc. v. Bartosh, No. 01-11-00793-CV2012, WL 4740859, at *2-3 (Tex. App.-Houston [1st Dist.] 2012, no pet.).
As an example of what the actual fraud rule allows one to get away with, look at the case of AvenueOne Props. v. KP5 Ltd. P’ship., 540 S.W.3d 643 (Tex.App.-Amarillo 2018, no pet.). The real estate broker defendant created a new company and openly moved substantial assets into it and out of the old company which was the object of the suit, effectively depleting the old company and rendering it judgment proof. The court denied the plaintiff’s attempt to pierce the veil of the new company, finding insufficient evidence of actual fraud.
In a case reminiscent of Texas’ cattle baron days, the alter-ego doctrine was found relevant to a judgment for reverse piercing (meaning accessing the LLCs assets as a result of an individual member’s fraudulent actions) where a member used the LLC as a mere “shadow of his personality.” The existence of actual fraud remained, however, an essential element of the ruling. Clement v. Blackwood, No. 11-16-00087-CV, 2018 WL 826856 (Tex.App.-Eastland 2018, pet. denied).
There is also a procedural barrier against veil-piercing. BOC Section 101.113 prohibits suing an LLC and a member in the same suit, which is problematic for a plaintiff since this is the typical way piercing cases are pursued. Since veil-piercing is not itself a cause of action, but only a means of imposing liability on an individual in the event a true cause of action (such as fraud) is proven, then piercing allegations cannot stand alone. They are subject to being dismissed for failure to state a proper cause of action.
Alter Ego Allegations
What does “alter ego” mean? “Under the [now-discarded] alter ego theory, courts disregard the corporate entity when there exists such unity between the corporation and individual that the corporation ceases to be separate and when holding only the corporation liable would promote injustice.” Mancorp, Inc. v. Culpepper, 802 S.W.2d 226, 228 (Tex. 1990). In other words, the company had failed in its mission to maintain itself as a legal entity independent of its owner. While Business Organizations Code Section 21.223(a)(2) eliminates the alter-ego theory as a basis for veil-piercing, it cannot be eliminated as a factor in a case where actual fraud is present, particularly since piercing in Texas has always been linked to values of fairness and justice.
During the discovery phase of a lawsuit involving a corporation or LLC, the plaintiff’s attorney will likely request production of the company book and all relevant company documentation. Purpose? If the company has no documentation other than a certificate of formation and a certificate of filing, the plaintiff’s attorney may then amend his pleadings to include alter ego allegations that are linked to allegations of fraud. In such instances, the defending attorney will always prefer that his client has a well-kept company book that can be produced in discovery.
In SSP Partners v. Gladstrong Investment (USA) Corp., 275 S.W.3d 444, 451-52 (Tex. 2008), the Texas Supreme Court stated that the limitation on entity liability may be ignored only when the corporate form has been used as part of an unfair device to achieve an inequitable result. Continuing this line of thought, the Houston Court of Appeals in Tryco Enterprises, Inc. v. Robinson, 390 S.W.3d 497 (Tex. App.-Houston [1st Dist.] 2012, pet. dism’d), stated that in order “[t]o pierce the corporate veil and impose liability under an alter ego theory of liability pursuant to SSP Partners, a plaintiff must show: (1) that the persons or entities on whom he seeks to impose liability are alter egos of the debtor, and (2) that the corporate fiction was used for an illegitimate purpose,” meaning “actual or constructive fraud, a sham to perpetrate a fraud, or other similar theory.” What factors are important in assessing whether or not such a fraud has occurred? The Court of Appeals in Tryco listed the following:
(1) whether the entities shared a common business name, common offices, common employees, or centralized accounting;
(2) whether one entity paid the wages of the other entity’s employees;
(3) whether one entity’s employees rendered services on behalf of the other entity;
(4) whether one entity made undocumented transfers of funds to the other entity; and
(5) whether the allocation of profits and losses between the entities is unclear.
Any and all of the above should be considered red flags in a piercing case. From an asset protection perspective, all can be avoided by sound planning and documentation. Looking at the broad picture, keeping good records remains a prudent thing to do, in spite of BOC Section 21.223(a)(3) which denies veil-piercing merely on the basis of failure by an LLC to observe traditional formalities. Why get into a potentially disastrous court fight about whether a certain measure is a mere “formality” or something more substantive, particularly given the inherent powers of a Texas court to enforce equity? Is failing to have an annual or special meeting approving borrowing money to acquire property for the company a mere formality or a serious lapse? If you do not think lawyers could engage in a serious battle on this point, then you do not know lawyers.
Piercing lawsuits remain relatively common even though the alter ego theory by itself has been essentially dead in Texas for quite some time. As a result, business lawyers defending LLCs and corporations are regularly called upon to expend resources responding to such cases. From an investor’s point of view, it is far better to take simple steps to document and regularly maintain the company (having annual meetings and so forth) so that these sorts of allegations will have no basis in the first place.
Corporate Rules Applied to Limited Liability Companies
The reader may note that the foregoing statute refers specifically to corporations. What about LLCs? Business Organizations Section 101.002 provides the answer by importing the piercing provisions of Section 21.223 into the realm of LLCs. In other words, the same standards apply to both corporations and LLCs even though provisions of the statute may refer to a corporation rather than an LLC and to shareholders rather than members. Accordingly, LLC members can expect to receive the same treatment as shareholders of a corporation, no more, no less. Penhollow Custom Homes, LLC v. Kim, 320 S.W.3d 366 (Tex. App.-El Paso 2010, no pet.).
Liability of Company Officers and Managers
The signature by a corporate officer or LLC manager does not, by itself, make that individual personally liable for company obligations, even if the signature line fails to specify that the signer is acting solely in his or her capacity as an officer or authorized representative. Neel v. Tenet HealthSys. Hosps. Dallas, Inc., 378 S.W.3d 597, 604-04 (Tex. App.-Dallas 2012, pet. denied). This rule tracks a central tenet of agency law: an agent is not liable on contracts made on behalf of a principal whose identity has been disclosed. Nonetheless, it is always the better practice to make sure that the signer on a contract fully discloses the capacity and authority to act on behalf of the entity for which he or she signs.
Directors and officers face full personal exposure, however, if the entity fails to pay its taxes. Tex. Tax Code §171.255. If a registered entity’s status is forfeited for nonpayment of taxes, then each director, officer, or manager may be held liable for debts of the entity from the date on which the tax was due up to the time the entity is reinstated. In re Trammel, 246 S.W.3d 821 (Tex. App.-Dallas 2008, no pet.).
Are single-member LLCs a problem?
Clients often worry whether or not the LLC liability shield will hold up if there is only one member. This is not a concern in Texas. This author does not know of a single case or circumstance where the firewall of a Texas LLC was pierced merely because it had only one member.
The only meaningful distinction relates to federal taxes. For federal tax purposes, the IRS considers a single-member LLC a “disregarded entity” (i.e., the IRS taxes the business just like it would tax a sole proprietorship). The profits or losses of the business are reported on the single member’s personal tax return on schedule C. That’s the extent of the difference in Texas.
The reason clients ask their attorney if a multi-member LLC is better for asset protection than a single-member LLC is because some states allow the holder of a judgment against an individual that owns 100% of an LLC to seize the judgment debtor’s LLC interest. This is not true in Texas, where a charging order is the exclusive remedy (in the absence of actual fraud, which is always the standard caveat in Texas contract, business, and real estate law).
Since Business Organizations Code Section 101.002 makes it clear that rules in this area relating to corporations also apply to LLCs, then (subject to the piercing rules outlined above) an LLC’s liability shield remains intact even though there is only one member.
Implications for Series LLCs
A series LLC (as opposed to a traditional LLC) allows for different compartments or series that are insulated from the assets and liabilities of other series within the company. While not technically separate legal entities, these individual series nonetheless behave as sub-companies capable of doing business independently of the company at large, entering into contracts, and holding title to property. There is not yet published Texas case law on this subject, although extensive precedent exists from other jurisdictions to which a Texas court may look for guidance in the series context. It is our view that even if a particular series is pierced, the other series within the company have the potential to remain intact.
Many business persons utilize online services or otherwise engage in no-frill LLC filings involving a one-page COF and the payment of a filing fee-and then believe they are safe from lawsuits. This may not be so if the company fails to follow up with a company agreement, issuance of membership certificates, minutes of meetings, and the like. While Section 21.223(a)(3) expressly eliminates the failure to observe corporate formalities as a basis for piercing, such failure may well be subtly considered as a factor by a real-world court in determining whether or not an actual fraud was perpetrated. Add an inflamed jury, one that is outraged at a perceived injustice, and the risk that a court will pierce the veil grows more likely. The law is not yet ruled by artificial intelligence. One cannot underestimate the human factor. It is more prudent to be safe than sorry when it comes to company documentation and other formalities.
What if documentation for an LLC or other entity has not been attended to for years? Fortunately, it is legal to go back in time and document a company’s activities, so long as this is not linked to actual fraud. Such documents are signed by the members as of a retroactive effective date, regardless of the date of actual signature.
Paying Franchise Taxes
Failing to pay Texas franchise tax and subsequent loss of the company’s charter can be disastrous for asset protection. Note the following from the Tax Code:
§ 171.255. Liability of Directors and Officers
(a) If the corporate privileges of a corporation are forfeited for the failure to file a report or pay a tax or penalty, each director or officer of the corporation is liable for each debt of the corporation that is created or incurred in this state after the date on which the report, tax, or penalty is due and before the corporate privileges are revived. The liability includes liability for any tax or penalty imposed by this chapter on the corporation that becomes due and payable after the date of the forfeiture.
(b) The liability of a director or officer is in the same manner and to the same extent as if the director or officer were a partner and the corporation were a partnership.
(c) A director or officer is not liable for a debt of the corporation if the director or officer shows that the debt was created or incurred:
(1) over the director’s objection; or
(2) without the director’s knowledge and that the exercise of reasonable diligence to become acquainted with the affairs of the corporation would not have revealed the intention to create the debt.
(d) If a corporation’s charter or certificate of authority and its corporate privileges are forfeited and revived under this chapter, the liability under this section of a director or officer of the corporation is not affected by the revival of the charter or certificate and the corporate privileges.
Trusts and Piercing Rules
Trusts – whether created for the purpose of anonymity, facilitating land transactions, or for probate avoidance – can be an important element in an overall asset protection structure. However, trusts are not legal entities in the same sense as a corporation or an LLC, although they often act like it in the real world. Trust agreements are not officially filed anywhere and have no state registration or approval requirements. Accordingly, there is no liability barrier and piercing rules do not apply. The participants in a trust-the trustor-grantor, the trustee, and the beneficiaries-are automatically exposed to lawsuits in their personal and individual capacities, which can be a dangerous position in which to find oneself. For this reason, investment trusts are most effectively used in conjunction with an LLC. The exception is a stand-alone living trust for the homestead since the homestead and related assets are already protected by Texas Constitution Article XVI, Section 50 and Property Code Chapters 41 and 42.
A related point worth making is that a judgment lien will not attach to trust property for which the judgment debtor is serving as trustee. Davis v. Gayer, 2004 WL 638140 (Tex.App.-Houston [1st Dist.]. Expect a hassle, however, from the plaintiff’s attorney if your “trust” has no written trust agreement to back it up, no deeds of property into it, no EIN or bank account, and no records.
The law applicable to piercing continues to evolve. The safest practice is to establish and maintain an LLC with thorough and ongoing documentation that is contained in a company book. Certificates for membership interests should also be issued. It is sound business practice to periodically document significant activities and events affecting one’s company using resolutions, special meetings, and the like, thereby pre-empting alter-ego type piercing allegations before they arise.
Information in this article is provided for general informational and educational purposes only and is not offered as legal advice upon which anyone may rely. The law changes. Legal counsel relating to your individual needs and circumstances is advisable before taking any action that has legal consequences. Consult your tax advisor as well. This firm does not represent you unless and until it is expressly retained in writing to do so.
Copyright © 2020 by David J. Willis. All rights reserved worldwide. David J. Willis is board certified in both residential and commercial real estate law by the Texas Board of Legal Specialization. More information is available at his website, www.LoneStarLandLaw.com.