UPDATE: In the aftermath of the Green Hunter Energy case, Wyoming legislature recently added two new subsections to its LLC Act that will make “piercing the veil” of a Wyoming LLC more difficult. The law has been amended to address the limited liability of Wyoming LLC Members, which was weakened by the Green Hunter decision:
(c) for purposes of imposing liability on any member or manager of a limited liability company for the debts, obligations or other liabilities of the company, a court shall consider only the following factors no one (1) of which, except fraud, is sufficient to impose liability:
(ii) Inadequate capitalization;
(iii) Failure to observe company formalities as required by law; and
(iv) Intermingling of assets, business operations and finances of the company and the members to such an extent that there is no distinction between them.
(d) In any analysis conducted under subsection (c) of this section, a court shall not consider factors intrinsic to the character and operation of a limited liability company, whether a single or multiple member limited liability company. Factors intrinsic to the character and operation of a limited liability company include but are not limited to:
(i) The ability to elect treatment as a disregarded or pass-through entity for tax purposes;
(ii) Flexible operation or organization including the failure to observe any particular formality relating to the exercise of the company’s powers or management of its activities;
(iii) The exercise of ownership, influence and governance by a member or manager;
(iv) The protection of members’ and managers’ personal assets from the obligations and acts of the limited liability company.
It is important to note that subsection (d) essentially states that Wyoming courts cannot pierce the LLC veil because of “factors intrinsic to the character and operation of a limited liability company”. This patches up the swiss cheese hole created in the Green Hunter decision, which the Wyoming Supreme Court created when it said that the company being a single-member LLC, and a disregarded entity for tax purposes, was a factor it considered in its decision to pierce the veil.
The following was originally published on this blog on November 15, 2014:
Many entrepreneurs and business owners ask, “Why form a Wyoming LLC?” or “Why start an LLC in Wyoming?” Now the experts are asking the same questions, because many view a recent case as the main reason not to have a Wyoming LLC. The Wyoming Supreme Court has undermined the strength of its single-member LLCs in a case that is hot off the presses. The case is troubling. Green Hunter Energy, Inc. v. Western Ecosystems Technology, Inc., No. S-14-0036, 2014 WL 5794332 (Wyoming Nov. 7, 2014). The opinion can be found here: http://www.courts.state.wy.us/Documents/Opinions/2014WY144.pdf. Green Hunter Energy, Inc., the sole member of Green Hunter Wind Energy, LLC (an LLC organized to develop a wind farm, but did not pay a contractor) was held to be liable for the debts of its subsidiary in a post-judgment collection action. Please share this and let others know about this outcome to help their businesses from suffering a similar fate by leaving the Wyoming LLC in the dust of Cheyenne.
The LLC veil is what protects the Member of the LLC from the liabilities associated with the underlying activities of the LLC itself. This is a protection that the law has permitted for decades to encourage people to enter into business with the expectation that problems of the “child” are not the problems of the “parent”. Even the Wyoming Supreme Court itself called the veil of protection “the most important legal development of the nineteenth century”, which was traditionally applied to corporations and later to alternative unincorporated entities, such as limited liability companies. This protection is afforded to the owners, in this case, the LLC’s parent (or Member), which was another entity. It can also be any person, such as a natural person or trust.
Without getting into the entire rationale, the Wyoming Supreme Court said that being a “disregarded entity” for tax purposes was a factor it considered in addition to the LLC being undercapitalized (without enough assets to pay its obligations). One expert called this “Dead Dog Wrong.” Undercapitalization alone is not usually sufficient to pierce an LLC veil. The court even cited a four factor test looking to see if there was 1) fraud, 2) inadequate capitalization, 3) failure to observe company formalities, and 4) intermingling the business and finances of the company and the member to such an extent that there is no distinction between them. This LLC generally followed formalities by keeping separate records and contracts. Some would say this makes the case for the use of multi-member LLCs because they file partnership tax returns over single-member LLCs that do not file separate tax returns. Instead with a single-member LLC, all profits and losses of the single-member LLC are reported on the Member’s tax return. This tax requirement should not be a factor in considering the child the alter ego of the parent. This is simply a tax classification and should not have been a factor for veil piercing because the company was filing taxes as required under the IRS Code. There was no other way to do it. Considering this was clearly erroneous and grounds for reversal of the lower court’s ruling. Therefore, Wyoming got it wrong.
The end result is to call into question the legitimacy of essentially all single-member LLCs in Wyoming, especially because no single-member LLCs file separate tax returns unless they elect to be taxed as either an S-Corp on IRS Form 2553 or C-Corp on IRS Form 8832. However, most single-member LLCs do not make this tax election and are not required to. Making such an election for holding passive assets would be malpractice because it would result in a capital gains tax trap.
Because Wyoming was the first US state to adopt the LLC in 1977, Wyoming has been an attractive jurisdiction for filing LLCs. In addition to its long history, it also became popular because it was inexpensive. In fact, when Nevada about doubled its cost to set up and run an LLC a couple years ago by requiring a business license filing, many Nevada LLCs converted to Wyoming. One registered agent with a huge number of Nevada LLCs actually encouraged its Nevada LLCs to convert to Wyoming as a reaction to the steep increase. It has been said that Wyoming can afford to offer such cheap LLCs because it has so much land and so few people that it does not need to tax its business entities as much and it has more than enough revenue through property tax and other taxes. In spite of those cheap filings and maintenance fees, it looks like the Wyoming Supreme Court has decided “you get what you pay for”, essentially a flimsy corporate veil and courts that consider irrelevant factors when deciding whether to honor the protection afforded under the law. Now the court has ruled that the Wyoming LLC has as many holes as Swiss cheese. Looks like it is time to move those Wyoming LLCs to Delaware or even back to Nevada.
The net outcome of this decision is the impact on all other single-member LLCs in Wyoming. What are they to do at this point? These are mainly LLCs organized to own assets and operate businesses outside Wyoming, although they are formed as Wyoming LLCs.
Fortunately there is a solution. The LLCs organized as Wyoming LLCs can file a Certificate of Conversion and reorganize in Delaware as a single-member Delaware LLC (Delaware SMLLC). In Delaware you are more likely to be struck by lightning than to have your LLC veil pierced. The process of filing a conversion is simpler that filing a merger and most commercial registered agents in Delaware, such as incnow.com, can assist with this process.
This case once again supports the notion of Delaware being the “Gold Standard” for LLCs, in part because the Courts in Delaware are smart enough not to consider IRS requirements when determining whether there is alter-ego liability. This is one reason why so many LLCs are organized in Delaware to own assets and run businesses outside Delaware, because of excellent statutes AND extraordinary business courts. Delaware is the preferred jurisdiction for LLC formation, no matter where you do business. If you think this Wyoming case is bad, I have no doubt the result would have been the same with many other states’ LLCs, particularly the weakest of them, including the Pennsylvania LLC and the California LLC. Therefore, take heed of this warning shot and plan ahead before you have a problem. Consider converting your LLC organized in another state to Delaware or start your new LLC in Delaware from the outset.