Farmers have several options when choosing their business's operating structure. Many farmers operate as sole proprietors and opt not to form a formal entity such as a corporation or limited liability company (LLC). After all, there is no requirement to form an entity to be in business. The most common reason farmers explore formal entity structures is their desire to protect personal assets from the liability inherent in most farming operations, and the structure that garners the most interest is the LLC.
There are good reasons for the LLC’s popularity. An LLC provides a measure of liability protection to its owners (members), while maintaining relative ease of formation and administration compared to corporations. The LLC structure also offers flexibility in federal income tax classification, defaulting to partnership taxation (or sole proprietorship treatment for a single-member LLC), while also permitting an election to be taxed as a C corporation, or S corporation, if eligible. Flexibility allows farmers to consider which tax structure meets their needs and choose accordingly when setting up the business. An added benefit is that the LLC structure can facilitate farm succession by allowing the gradual transfer of ownership interests.
While an LLC is a solid entity choice for many farms, forming one does not provide unlimited protection or guarantee that members will be shielded from personal liability. Here, we review the general rules governing LLCs and the liability protection they provide. Because specific laws vary by state, the discussion is limited to general principles. Readers must consult with an attorney in their state to understand the specific laws of their state.
Liability Protection Is Not Unlimited
An LLC, when properly formed, is a distinct legal “person,” separate from its member-owners. An LLC can do business, enter into contracts, purchase assets, borrow money, and engage in other activities in its own name. Each member owns a share of the LLC. When things are done properly, the member acts on behalf of the LLC rather than in an individual capacity when doing business. From a liability perspective, the LLC is responsible for its activities, including performing under contracts, repaying debts, and incurring liabilities arising from its operations.
For example, if the LLC fails to perform under a contract and is sued for damages, the LLC is generally responsible, not the individual member. The member may lose value in their LLC interest, but they typically will not be personally liable beyond the value of their interest. However, there are important limitations to the protection an LLC provides to members. These limitations are discussed below.
Member’s Own Tortious Conduct
The LLC structure will not protect a member from liability arising from the member’s own tortious conduct, even when the member is acting on behalf of the LLC. Tortious conduct is a legal term referring to wrongdoing that causes harm to another person. In most jurisdictions, a member may be personally liable for their own tortious conduct, whether intentional or negligent.
A classic example is an LLC member who causes an accident while driving a tractor or vehicle owned by the LLC. Even if the member was conducting LLC business and operating the tractor or vehicle on the LLC's behalf, both the LLC and the member may potentially be held liable. Lawsuits may be brought against both the LLC and the member, placing both the LLC’s assets and the member’s personal assets at risk. Other LLC members who were not involved in the accident are generally not personally liable, and their losses are typically limited to the value of their ownership interests.
To mitigate the risk to LLC assets and the LLC's overall value, members should confirm that the LLC is adequately insured and that coverage includes all LLC activities and operations. A common mistake is forming an LLC but failing to obtain insurance in the LLC’s name or to update existing policies to properly cover LLC operations. This can leave the LLC without adequate coverage for claims. To mitigate the risk to personal assets, members should consider insurance that extends to their actions.
Member Guarantees
The LLC structure does not provide liability protection for obligations a member assumes in an individual capacity. For example, many lenders require one or more LLC members to personally guarantee LLC loans or co-sign financing agreements. If the LLC fails to repay the loan, the guarantor-member may be personally responsible for repayment, and their personal assets may be subject to collection efforts or enforcement of a judgment.
Lenders may also require spouses to sign guarantees or co-sign on loan documents in their personal capacity, even if the spouse is not an LLC member. They also may be liable for payment if the LLC fails to repay.
Piercing the Corporate Veil
The LLC structure will not provide the intended personal liability protection for members where the legal doctrine commonly known as “piercing the corporate veil” applies. This doctrine allows a court, in limited circumstances, to disregard the LLC’s separate legal existence and impose liability directly on members.
Piercing the corporate veil is generally considered an extraordinary remedy reserved for cases where the LLC structure has been abused to perpetrate fraud, injustice, or inequitable conduct or where owners have not treated the LLC assets as separate from their own. The specific standards and factors applicable to veil piercing vary by state statute and judicial precedent. Therefore, members should understand the laws of the state in which the LLC is formed and operating.
To reduce the risk of veil piercing, LLC managers and members should follow best practices, including maintaining separate LLC accounts and records, avoiding commingling LLC and personal assets, and ensuring the LLC is appropriately capitalized for its operations.
Unpaid Employment Taxes
If an LLC has employees, members may be held personally liable for certain unpaid employment taxes. Under federal tax law, when an employer collects or withholds payroll taxes from employees, the withheld amounts are considered held in a special fund in trust for the United States. If the LLC fails to deposit these trust fund taxes as required, the Internal Revenue Service (IRS) can impose a personal penalty equal to the total amount of unpaid tax on any "responsible person" who willfully failed to collect, account for, or remit the taxes.
An LLC member is considered a "responsible person" if they have the power or authority to pay the taxes, considering factors such as whether the member manages the day-to-day operations of the business, has control over the payroll, has the authority to hire and fire employees, determines which bills to pay, and controls bank accounts.
A member of a single-member LLC taxed as a disregarded entity can be held responsible regardless of the factors listed above. When a single-member LLC operates as a disregarded entity, the sole member is treated as a sole proprietor for federal tax purposes. Consequently, the owner is directly and individually liable for all federal employment taxes owed by the business.
Member’s LLC Interest
It is important to remember that an LLC member’s ownership interest in the LLC is itself a personal asset. While a member may not directly own the LLC’s underlying assets, the member’s LLC interest is an asset that has value and may be subject to creditor claims or division in legal proceedings.
If an LLC member is sued in their individual capacity and found liable for damages, the member’s LLC interest may be subject to judgment enforcement or other creditor remedies.
For example, if an LLC member defaults on personal loans or other obligations, a creditor may seek to attach the member’s LLC interest. Typically, this takes the form of a charging order, essentially a type of lien, on the member’s LLC interest. A charging order generally gives the creditor the right to receive distributions that would otherwise be paid to the debtor-member, but it does not give the creditor management rights or direct access to LLC assets. In general, charging orders do not disrupt operations or force non-debtor members into an involuntary relationship with the creditor. Charging order protections vary by state, and in the case of single-member LLCs, some states may allow creditors broader access to LLC assets because the protection of other members' interests is not a factor.
LLC Interests in Divorce Proceedings
The treatment of LLC interests in divorce proceedings varies depending on state law, the nature of the LLC interest, how and when the interest was acquired, and the specific facts of the case.
An LLC interest is often considered part of the marital estate, like other assets. Depending on the state and circumstances, the interest may be classified as marital property, separate property, or a mix of both. If only one spouse is a member of the LLC, courts may consider factors such as when the interest was acquired, whether it was acquired by gift or purchase, the source of funds used to acquire it, and whether the interest's value appreciated during the marriage. In some states, even if the LLC interest itself is separate property, appreciation in value attributable to marital efforts or contributions during the marriage may be treated as marital property.
While the value of the LLC interest is often considered in the marital estate, courts frequently also consider the terms of the LLC operating agreement. If the operating agreement restricts ownership transfers and a transfer to the spouse would violate those restrictions, courts may instead award offsetting assets or monetary value to the non-member spouse rather than transferring the LLC interest itself. In some cases, courts may also consider valuation methods included in the operating agreement when determining the value of the LLC interest for divorce purposes.
Accordingly, while an LLC does not provide a mechanism to exclude a business interest from a divorce estate, an operating agreement that restricts transfers and addresses succession of ownership can reduce the likelihood that a divorcing spouse will obtain an ownership interest in the business. It is worth noting that this may not be the case with single-member LLCs, and a forced sale may be more likely under some state laws.
State Law Controls
Because the law governing LLCs varies by state, members should consult legal counsel regarding the laws applicable in the state where the LLC is formed and operates.
The Beginning Farmer Center does not provide legal advice. Any information on this website is for educational purposes only and is not intended to be a substitute for legal services from a competent professional.