What Is Adequate Capitalization in an LLC?
The name itself -- limited liability company -- provides a primary reason for setting up your business as an LLC. Limited liability means you as an owner in an LLC would not be responsible for debts or claims against the LLC business out of your personal assets. However, the courts will not uphold a limited liability claim from the ownership in an LLC if it is determined that the business was not adequately capitalized.
When a limited liability company is formed, the business is capitalized by the money the owners put into the business when each pays for his ownership share. An LLC can add to the initial amount of capitalization by taking out loans in the name of the company. The LLC owners may also provide loans to the company. The money invested in a new LLC by the owners and any funds borrowed in the name of the company becomes the capital the business can use to conduct operations and pay the bills.
An adequate level of capitalization provides enough money for a business to cover its financial obligations. If the company is doing well, the profits from sales of goods and services will be enough to pay expenses and other obligations. However, if the revenue or profits generated by the business fall short of what the company must pay out, money in the bank due to the initial or ongoing capitalization efforts of the owners is needed to pay the bills until business results improve.
The most telling sign of inadequate capitalization happens when an LLC runs out of money, closes the doors and declares bankruptcy. Of course it is possible for a new business idea to just not work out and for the owners to close out the company instead of throwing more good money into an idea that won't work. Inadequate capitalization would be if the analysis of a business idea indicates that $1 million is needed to properly fund the new LLC, and the owners elect to contribute just $100,000 as the capital to start and support the early days of the company. The less-than-adequate level of initial funding almost guarantees that the company will fail.
If, when the owners of a failed LLC are taken to court, the bankruptcy court decides that the company was not adequately capitalized, the limited liability protection can be broken, and creditors of the company can go after the assets of the LLC owners. The determination of adequate capitalization depends on the type of business and the reasoned opinion of the bankruptcy judge. The owners of a failed LLC need to be able to show that the money they put in to fund the business should have been sufficient under typical business conditions for the type of undertaking.