Jeffrey L. Smoot Oles Morrison Rinker & Baker LLP 701 Pike Street, Suite 1700 Seattle, WA 98101 (206) 623-3427 smoot@oles.com THE CORPORATE SHIELD: USE IT OR LOSE IT by Jeffrey L. Smoot One of the primary reasons a closely held business owner incorporates or forms a limited liability company ( LLC ) is to protect the owner from individual liability for claims against the business. Incorporating or forming an LLC can be an effective shield for the individual owner or shareholder against potential personal injury or property damage claims arising from accidents occurring on the business premises, product liability claims, and creditor claims against the business entity. For this reason, most business owners are well advised to form a corporation or LLC to operate their business (and if they also own the premises upon which the business operates, a separate corporation or LLC to hold title to the property). However, despite doing so, many business owners still find themselves defending against lawsuits seeking to disregard the business entity and impose personal liability on the owners. And, in many cases, an owner ends up with a judgment against him- or herself individually despite the intended legal protection afforded by the corporation or LLC form. Many a well-intentioned business owner has lost not only their business, but ended up in personal bankruptcy, because they did not respect the separate form of the corporation or LLC and, in doing so, subjected themselves to personal liability for claims against which they would otherwise have been protected. Therefore, it is crucial for every business owner to understand the protections against individual liability afforded by the corporation and LLC form, and the formalities that must be observed to preserve those protections. Oles Morrison Rinker & Baker LLP 701 Pike Street, Suite 1700, Seattle, WA 98101 www.oles.com
Sole-Proprietorship A sole proprietor is the most basic form of business entity. It is simply an individual who conducts business in his or her own name or under a trade name. As such, the sole proprietor offers absolutely no protection to the owner against claims against the business. The owner is individually liable for all legal claims that are asserted against the business because he or she is the business. As an example, say John Doe owns J.D. Construction, and a day laborer drops a hammer that strikes a passerby in the head, causing traumatic brain injury. John, the individual business owner operating as a sole-proprietor, will be individually liable for damages even though he had nothing directly to do with causing the passerby s injury. Negligent acts of employees and agents committed within scope of their employer s or principal s business are imputed to the employer or principal under the doctrine of respondeat superior or vicarious liability. The best defense against individual liability for a sole-proprietor or any business, really is insurance. But business owners can protect themselves from the negligent acts of employees and agents, and other claims against the business, by incorporating or forming a limited liability company or other limited-liability entity. The Corporate Shield As the U.S. Supreme Court ruled (sort of) in its Citizens United v. Federal Election Commission decision, corporations are people, too. Although technically not individuals, corporations and LLCs are distinct legal entities from their owners. A corporation is an artificial entity which can only act through its officers, employees, and other agents. See Opportunity Christian Church v. Washington Water Power Co., 136 Wash. 116, 120, 238 P. 641 (1925); see also Dickens v. Alliance Analytical Laboratories, LLC, 127 Wn. App. 433, 111 P.3d 889 (2005) (an LLC is an artificial entity that must act through its members or managers). As such, a corporation itself is generally liable for the authorized acts of its agents. Tacoma Hotel v. Morrison & Co., 193 Wash. 134, 74 P.2d 1003 (1938); Dickens, 127 Wn. App. at 440 (RCW 25.15.060 provides that members of an LLC shall be personally liable for any act, debt, obligation, or liability of the LLC to the extent that shareholders of a corporation would be liable in analogous circumstances). This effectively means that a corporation has separate legal status from its owners, and is separately liable for its own obligations; its owners are not individually liable for acts, omissions or debts of the entity unless they personally committed acts or omissions that proximately caused those damages or are otherwise personally liable for the debts. Washington courts have recognized that a limited liability company is a statutory business structure that is like a corporation in that members of the company are generally not personally liable for the debts or obligations of the company, although it can be similar to a partnership for tax purposes. Chadwick Farms Owners Ass n v. FHC, L.L.C., 166 Wn. 2d 178, 186-87, 207 P. 3d 1251 (2009); see also RCW 25.15.125 (generally 2
members of an LLC are not personally liable for the LLC s debts, obligations or liabilities, with listed exceptions). Using the above scenario, if John Doe is the sole shareholder of J.D. Construction, Inc., the corporation may be held liable for damages resulting from the laborer s negligence (and the laborer may be held liable individually for his own negligence), but John will normally be shielded from individual liability because the business is a corporation which is a distinct legal entity from John. Similarly, if John formed his construction business as an LLC, he will be shielded from individual liability for legal claims in most cases. However, this corporate shield is not impenetrable. For example, if John was the one who dropped the hammer, he would ordinarily be personally liable due to his own negligence, which will also be imputed to the corporation since John, an agent of the corporation, committed the negligent act within the scope of his agency relationship. And if John hired the laborer who dropped the hammer, and the laborer had a documented history of causing similar accidents, or John blatantly disregarded OSHA safety requirements which resulted in the accident, he could be held personally liable under a theory of negligent hiring or negligent supervision. Debts Incurred Prior to Incorporation/LLC Formation or After Dissolution A person conducting business under the name of a corporation or LLC that has not yet been formed has potential personal liability for pre-incorporation acts and conduct. Persons may be liable for their alleged corporate acts undertaken before incorporation if they act knowing there was no corporation. RCW 23B.02.040; Equipto Division Aurora Equipment Co. v. Yarmouth, 134 Wn.2d 356, 950 P.2d 451 (1997). In order to be held personally liable to a third party for actions taken before incorporation, an officer/director must have actual knowledge the corporation had not yet been formed; constructive knowledge is not enough. Id. Likewise, if after administrative dissolution the corporation continues to conduct ongoing business, the persons conducting that business will be individually liable if they have actual knowledge of the dissolution. Id.; see also White v. Dvorak, 78 Wash. App 105, 896 P.2d 85 (1995). Piercing the Corporate Veil Creditors who are unable to recover their damages or debts from a corporation or LLC will often attempt to impose personal liability on the company s owners, members or shareholders, particularly in closely held corporations and LLCs. This is known as corporate disregard, piercing the corporate veil or alter ego. Generally, corporate disregard theories are applied to shareholders and LLC members. Creditors are most likely to sue whomever has deep pockets, i.e., the highest likelihood of having sufficient assets or insurance to pay. Often, business owners have assets that they have accumulated from the profits of the business over time; when the business fails or does not have sufficient assets to pay creditor claims, it is the owners who become the deep pockets from which creditors hope to be paid. 3
Two essential factors must be proved to pierce the corporate veil. First, the corporate form must be intentionally used to violate or evade a duty. Second, disregard must be necessary and required to prevent unjustified loss to the injured party. Meisel v. M&N Modern Hydraulic Press Co., 97 Wn.2d 403, 409-410, 645 P.2d 689 (1982) (citing Morgan v. Burks, 93 Wn.2d 580, 585, 611 P.2d 751 (1980). Intentional misconduct must be the cause of the harm that is avoided by the disregard. Meisel, 97 Wn.2d at 410; see also Truckweld Equip. Co. v. Olson, 26 Wn. App. 638, 618 P.2d 1017 (1980) (type of injustice required for corporate veil piercing is one involving fraud, misrepresentation, or some form of manipulation of the corporation to the stockholder s benefit and creditor s detriment). Personal Guaranty of Debts A guarantor is a fool with a pen. ~Anonymous Many creditors require that business owners personally guaranty repayment of loans and other obligations; in particular, commercial landlords almost always require a personal guaranty signed by all owners of a corporation or LLC. In cases where a personal guaranty is required and specifically negotiated, guaranteeing the debts of the business entity is usually unavoidable. However, many business owners and even employees fail to read the fine print in purchase orders and credit applications that include language holding the signer of the documents liable as a guarantor, and are surprised to find out later when they are sued personally for the business debts they have inadvertently guaranteed. Under RCW 19.36.010, a debt for a special promise to answer for the debt, default, or misdoings of another person is enforceable if it is in writing. Courts could conceivably enforce these guarantees even if the signer was not an owner of the company, but merely the delivery driver who signed on behalf of the company. Even if the guarantor signed unintentionally and eventually prevails in avoiding personal liability for the business s debt, the fact that he or she signed a document containing a personal guaranty will almost certainly result in the signer being named in a lawsuit if the business fails to pay the debt. Individual vs. Representative Capacity Another common mistake made by business owners is to sign contracts and other documents in their own name, without referencing their status as an officer or member of the corporation or LLC. Typically, an officer/agent is not liable to a third party for the breach of a contract signed by an authorized corporate agent; the corporate principal alone is liable. Corporate officers and directors and LLC managers and members should always sign in their representative capacity ; that is, they should always indicate that they are signing as an officer, director, manager or member of the LLC whenever they sign any document. Generally, officers, employees and other agents are not liable on authorized contracts 4
which they sign on behalf of the corporation, as long as they disclose their representative capacity. State v. Hanson, 59 Wash. App 651, 800 P.2d 1124 (1990); Hopkins v. Anderson, 7 Wash. App 762, 502 P.2d 473 (1972); Pacific Power & Light Co. v. Norris, 194 Wash. 91, 77 P.2d 379 (1938); Wilson v. Mears, 105 Wash. 296, 117 P 815 (1918); Weeks v. Kerr, 486 NE2d 10 (Ind App 1985). As an example, John Doe could sign in his representative capacity as follows: J.D. Construction, Inc. John Doe John Doe, Its President If he merely signs his own name and does not indicate that he is signing as the President of J.D. Construction, Inc., he could be held personally liable for payment of a debt associated with that document. In Sneed v. Santiam River Timber Co., 122 Or 652, 260 P 237 (1927), the corporate name was mentioned in the document and one of the two signing officers remembered to add his title. The court in that case did not impose liability upon the more forgetful officer. On the other hand, even if an officer fails to mention the principal s name and the officer s agency capacity, the officer will not be liable if the other party otherwise knows of such facts and knows that the officer intended to bind only the corporation. See Coxwell Tractor & Equipment Sales, Inc. v. Burgess, 192 Ga App 663, 385 SE2d 753 (1989). Alter Ego An alter ego claim asserts that the corporation or LLC is not really separate and distinct from its owners. Typically, an alter-ego claim asserts that the owners are acting as if the corporation or LLC did not exist, such as by failing to observe corporation formalities, commingling of assets, taking cash out of the till, using company funds to pay for personal expenses, or otherwise running the business as if it was a sole proprietorship. Many small business owners do things on a daily basis that expose them to potential alter-ego liability. They should have a CPA or attorney review their accounting records periodically to help them clean up a mess before a tax audit or a creditor lawsuit. Failure to Observe Formalities A corporation or LLC is governed by statutes, articles of incorporation, bylaws, operating agreements, and resolutions. A corporation or LLC that fails to follow statutory requirements or its own governing documents can be disregarded. For example, failing to hold an annual meeting, taking actions that require a meeting and a vote without a meeting or a vote, or failing to recording decisions in the minutes can result in an alter- 5
ego claim. Even failing to put Inc. or LLC on the company stationery or business cards can lead to personal liability claims against the owner. Commingling of Assets An alter-ego claim can also result from commingling of assets. Many closely held corporations or LLCs are owned by one or two people, often family members, who do not always maintain separation between their personal and business finances. For example, they may pay personal debts such as their mortgage or car payments out of their business checking account; purchase assets for personal use in the name of the company (and write them off as business expenses); or even buy groceries and pay for family vacations using the company credit card. Sometimes this is done for tax purposes (to claim write-offs or depreciation that they really should not be claiming); and often the owners treats these personal expenses as draws or advances on distributions. However, if the company begins to struggle financially and creditors or investors find out that the owner is using company funds to maintain his or her lifestyle at their expense, they will likely sue the owner individually for improperly commingling company and personal finances. In such cases, creditors could seek a judgment against the owner individually, or could assert a claim for constructive trust against the assets the owner purchased with company funds, asking the court to find that the asset (possibly the owner s home, children s cars, season tickets) is really owned by the company and should be sold to pay the company s debts. When multiple creditors are suing a company and its business owners to recover personal assets with company funds, the company often winds up in bankruptcy or receivership, along with the individual owners. Undercapitalization If a corporation or LLC does not have sufficient capital to fund its operations, a court could find that the company was never sufficiently distinct from its owners to be a distinct legal entity. Undercapitalization typically occurs when a corporation or LLC incurs a debt for which it does not have sufficient financial resources to repay. The owners, hoping the loan will turn things around, are eager to take the money, but if the business does not turn around, the creditor will likely sue the owners individually for repayment of the loan even if they did not personally guarantee payment. An owner may also take excessive draws from the company, leaving insufficient funds to pay debts; this can also result in alter-ego liability. Ultra Vires Acts Officers and directors who commit ultra vires acts corporate acts that are not authorized by the bylaws or consent can be held personally liable for those acts. For example, if a corporate officer enters into a contract without authorization or consent, or signs a contract that has been voted against by the board, that contract may be held void as to the corporation, but can be enforced against the officer individually. 6
Likewise, a corporate agent is personally liable on a contract which the agent signs for the corporation, but which act exceeds the agent s actual authority. Deers, Inc. v. DeRuyter, 9 Wash. App 240, 511 P.2d 1379 (1973). Some one must be bound by the contract, and, if he does not bind some other, he binds himself. Rowley v. Hager, 63 Or. 246, 249, 127 P. 36, 37 (1912). Officer and Director Liability In addition to alter-ego and piercing the veil claims, officers and directors of a corporation and managers and members of an LLC can be personally liable in a number of instances. Owners who transfer company assets to themselves, family members or other insiders when the business is struggling financially or facing a lawsuit can be held personally liable for paying the value of the transferred assets back to the company to satisfy creditor claims. Even if they are also creditors of the corporation, officers and directors cannot use their positions to obtain for themselves an unfair advantage over other corporate creditors. In particular, officers and directors may be held liable to other corporate creditors if the officers/directors diverted corporate funds to themselves when the corporation is insolvent or at time of dissolution. Tacoma Association of Credit Men v. Lester, 72 Wn.2d 453, 433 P.2d 901 (1967). Often, owners will pay themselves deferred salary or repay their capital contributions to the company just before closing down the business, leaving no funds for creditors. Of course, owners will be individually liable for conversion of company assets or assets belonging to third parties, including funds loaned to or invested in the company used for unauthorized purposes, inducing third parties to loan or invest money in the company under false pretenses, or using trust funds for unauthorized purposes. But owners of a corporation or LLC also have a duty to pay the debts of the company before paying themselves; if they choose to pay themselves, their relatives, or their close business associates first, or to pay down personally guaranteed debts, they subject themselves to personal liability not only for the amount of those payments, but possibly for all debts of the company. They may find themselves not only facing a lawsuit, but potentially an involuntary bankruptcy filing. Officers and directors are liable if they make fraudulent statements to third parties, and any fraudulent act of the corporation that they participate in, approve, or adopt. Officers and directors have an affirmative duty to be aware of the companies they serve and they can be held liable for activities of other officers and directors which they reasonably should know about. Senn v. Northwest Underwriters, Inc., 74 Wn. App 408, 414, 875 P.2d 637, 640 (1994). If a corporate officer participates in wrongful conduct or with knowledge approves of the wrongful conduct, then the officer, along with the corporation, is liable for any resulting injury. See Grayson v. Nordic Constr. Co., 92 Wn.2d 548, 553-54, 599 P.2d 1271 (1979); State v. Ralph Williams N.W. Chrysler Plymouth, Inc., 87 Wn.2d 298, 322, 553 P.2d 423 (1976). For example, officers and directors can be liable for making false representations about the financial condition of the corporation. Pacific Fruit & Produce Co. v. Modern Food Stores, Inc., 158 Wash. 7
212, 290 P 859 (1930). As an example, if the corporation solicits investments through illegal solicitation or misleading or inaccurate disclosures that the owner is aware of and allows, even if he or she did not personally participate in preparing the disclosures or soliciting investments improperly, he or she may still be personally liable for any injury to the investors. However, an officer who does not knowingly commit or approve a wrongful act is not held personally liable. See Annechino v. Worthy, 175 Wn.2d 630, 637-38, 290 P.3d 126 (2012); Consulting Overseas Mgmt., Ltd. V. Shtikel, 105 Wn. App. 80, 86, 18 P.3d 1144 (2001). Corporate officers and agents may be liable for tortuous interference when they act to cause the corporation to breach a contract for substantially personal reasons or for spite or ill will. See Hein v. Chrysler Corp., 45 Wn.2d 586, 277 P.2d 708 (1954). Officers and directors are liable if the violate the standards of care imposed upon them by RCW 23B.08.300 and 23B.08.420, which include acting in good faith, with the care of an ordinarily prudent person in a like position would exercise under similar circumstances, in a manner the director reasonably believes to be in the best interests of the corporation. Corporate officers may be held criminally responsible for an unlawful corporate act in which they were involved. State v. Thomas, 123 Wash. 299, 212 P 253 (1923); Dodson v. Economy Equipment Co., 188 Wash. 340, 62 P.2d 708 (1936); State v. Paggett, 8 Wash. 579, 36 P 487 (1894). Unlawful Withholding or Rebate of Wages Corporate officers and agents can also be personally liable for unpaid wages, together with double damages and attorney s fees. RCW 49.52.050 provides: Any employer or officer, vice principal or agent of any employer, whether said employer be in private business or an elected public official, who (1) Shall collect or receive from any employee a rebate of any part of wages theretofore paid by such employer to such employee; or (2) Wilfully and with intent to deprive the employee of any part of his or her wages, shall pay any employee a lower wage than the wage such employer is obligated to pay such employee by any statute, ordinance, or contract; or (3) Shall wilfully make or cause another to make any false entry in any employer s books or records purporting to show the payment of more wages to an employee than such employee received; or (4) Being an employer or a person charged with the duty of keeping any employer s books or records shall wilfully fail or cause another to fail to show openly and clearly in due course in such 8
employer s books and records any rebate of or deduction from any employee s wages; or (5) Shall wilfully receive or accept from any employee any false receipt for wages; Shall be guilty of a misdemeanor. RCW 49.52.070 provides that: Any employer and any officer, vice principal or agent of any employer who shall violate any of the provisions of RCW 49.52.050 (1) and (2) shall be liable in a civil action by the aggrieved employee or his or her assignee to judgment for twice the amount of the wages unlawfully rebated or withheld by way of exemplary damages, together with costs of suit and a reasonable sum for attorney s fees The violations by an employer or any officer, vice principal, or agent of any employer of any of the provisions of subdivisions (3), (4), and (5) of RCW 49.52.050 shall raise a presumption that any deduction from or underpayment of any employee s wages connected with such violation was willful. Essentially, whenever an employer (business owner, manager, controller) attempts to stiff employees on their compensation, for whatever reason, the individual responsible for paying can be held personally liable. Thus, great care must be taken to assure that employees are paid. If a company is experiencing financial difficulty and yet continues to require employees to work with knowledge that they might not be paid especially if the decision makers get paid the individual owners, managers or other vice-principals can be held personally liable for payment of that compensation, doubled, plus attorney s fees. They can also be held criminally liable for wage theft, especially if they paid or transferred company assets to themselves while not paying employees. Failure to Pay Certain Taxes and Discharge Legal Duties of a Business Entity The Internal Revenue Code imposes personal liability and penalties against any person required to collect, truthfully account for, and pay over any taxes imposed by the Code, including FICA (social security) and withholding taxes. 26 U.S.C 6672. This liability attaches to all who have a significant word as to what bills should or should not be paid, and when and may be imposed on corporate officers and directors. Turner v. United States, 423 F2d 448, 449 (9th Cir 1970). The corporate form does not shield officers and directors from individual liability under this Fair Labor Standards Act, 29 U.S.C 203(d), for an action taken on behalf of the 9
corporation in its dealings with employees. Donovan v. Maxim Industries, Inc., 552 F Supp 1024 (D.Ma.1982). Section 15 of the Securities Act of 1933, Section 20 of the Securities and Exchange Act of 1934, and RCW 21.20.430(3) all impose liability on officers and directors for corporate violations of the securities laws. See, e.g., Hines v. Data Line Systems, Inc., 114 Wn.2d 127, 787 P.2d 8 (1990). Officers and directors may be liable for corporate violations of the federal antitrust laws. United States v. Wise, 370 U.S. 405 (1962); Allen Organ Co. v. North American Rockwell Corp., 363 F Supp 1117 (E.D.Pa.1973). Under RCW 23B.08.320, a corporation s articles of incorporation may contain provisions that eliminate or limit the personal liability of a director for monetary damages for conduct as a director, provided those provisions do not eliminate or limit the liability of a director for acts or omissions that involve intentional misconduct or a knowing violation of law. The business judgment rule generally protects officers and directors of a corporation (or LLC) from personal liability for exercise of poor but honest business judgment, but not for intentional misconduct or illegal acts or omissions. Under RCW 50.24.230, upon termination or dissolution of a corporation or LLC, a business officer, member or owner who has control or supervision of payment of unemployment tax contributions who willfully evades contributions, destroys or falsifies records, or fails to truthfully account for or makes a false statement under oath relating to the financial condition of the business, is personally liable for any unpaid contributions, interest and penalties on those contributions. However, there is an exemption if the assets of the business have been applied to its debts through bankruptcy or receivership. RCW 50.24.230(3). Under RCW 82.32.145, whenever the Department of Revenue has issued a warrant for collection of unpaid trust fund taxes (e.g., sales taxes collected but not paid to the state; see WAC 458-20-217(8)) from a limited liability business entity that has been terminated, dissolved, abandoned or is insolvent, the Department may pursue collection against the responsible individuals (WAC 458.20.217(9)). The Department may presume that an entity is insolvent if the entity refuses to disclose to the department the nature of its assets and liabilities. A responsible individual who was a current or former chief executive or chief financial officer is personally liable for those trust fund taxes that accrued during his or her period as CEO or CFO, and also during the period of time that he or she had a duty to pay the taxes but was not the CEO or CFO. Worse, RCW 9A.08.030 provides that a person is criminally liable for conduct constituting an offense which he or she performs or causes to be performed in the name of or on behalf of a corporation, and that, if the agent of a corporation fails to perform an duty imposed by law on a corporation, he or she is criminally liable for such conduct to the same extent as if the duty were by law imposed directly upon such agent. 10
Successor Liability Successor liability may occur when there is a merger or consolidation of two or more business entities. This can occur where the purchaser of a corporation or LLC agrees to assume the debts of the company; where the transaction amounts to a de facto merger or consolidation; the purchaser or transferee is a mere continuation of the seller; or the transaction is a constructively fraudulent attempt to avoid liability for the debts of the seller. Obviously, if the purchaser of a company s assets agrees to pay its debts, it will have successor liability. However, courts will impose successor liability on the purchaser or the successor business entity for many reasons. Courts look to various factors as indicia of de facto merger or consolidation, mere continuation, or fraud, including but not limited to: Continuity of management, personnel, physical location, assets, clientele, and business operations Continuity of ownership of the seller and purchaser The purchaser is merely a restructured or reorganized form of the seller The purchase price was inadequate consideration for the assets purchased The seller was insolvent when the assets were transferred The seller was undercapitalized at the time of the transfer or because of the transfer The seller ceases business operations immediately after the transfer The transaction was not at arm s length The purchaser continues to manufacture the same products as the seller The purchaser uses the same name as the seller There does not have to be a sale for successor liability to apply. If John Doe decided to shut down J.D. Construction, Inc. and start up J.D. Construction, LLC using the same personnel, location, and equipment, and doing the same type of work for the same clientele, at a time when creditors were threatening to sue the corporation, J.D. Construction, LLC could very well have successor liability to creditors of J.D. Construction, Inc. At the very least, both companies and their owner can expect to be involved in contentious, expensive litigation. Single-Member LLCs While many business owners choose the LLC form for their businesses, they should be aware that the LLC form does not offer complete protection from creditors for single owners. This theory holds that an LLC, being a form of partnership, is designed to protect the partners or members from the debts or obligations of the other members. Creditors have limited recourse against a member s interest in the LLC; usually their only remedy is to obtain a charging order against the LLC and hope that the LLC will make a distribution to the debtor member at some point in the future. However, in a singlemember LLC, there are no other members interests to protect. If the owner is the sole 11
member of the LLC, a court could find that the LLC was merely the alter-ego of the owner and disregard the protection of the LLC, exposing all the owner s assets to payment of the creditor s claim. Likewise, in bankruptcy, a trustee can disregard the LLC form and treat the owner s economic and management interest in the LLC as property of the bankruptcy estate. See Fursman v. Ulrich (In re First Protection, Inc.), 440 B.R. 821 (9th Cir. BAP 2010). For this reason, it may be advisable in some situations to form an LLC with more than one member. Family partnerships and LLCs often have two or more members from the same immediate family; these LLCs are more closely scrutinized than LLCs that have unrelated members. See Batman v. Commissioner, 189 F.2d 107, 111 (5th Cir. 1951). Assuming these family partnership or LLC members observe all formalities and do not commit any misconduct toward their creditors or third parties, the LLC form is generally respected by courts and bankruptcy trustees; however, they must take great care to observe all formalities, as any failure to do so could lead to piercing of the partnership or LLC form by a bankruptcy trustee or creditor. Avoiding Personal Liability for Business Debts While there is no guaranty that a creditor will not sue a corporation or LLC owner individually, there are steps a business owner can take to minimize the risk of personal liability or successor liability. Be sure both you and your business are adequately insured! Be honest in your business dealings and exercise your business judgment in good faith. Form a corporation or LLC to limit personal liability. Consider a multi-member LLC vs. a single-member LLC. Make sure that all LLC members pay adequate consideration for any assets/value they receive. Always sign documents relating to business activities in your representative capacity. Always read the fine print so you don t inadvertently guarantee payment of business debt. Observe all corporate and LLC formalities; follow the bylaws and operating agreements, conduct regular meetings, and record all decisions in the minutes. Maintain rigorous separation of your personal and business finances. Do not commingle funds or assets; use business funds and assets only for business purposes, and keep good accounting records. Hire a CPA and attorney to review all business financial transactions to help avoid inadvertent commingling or other financial transactions that might lead to personal liability. Do not title any personal assets in the business name, and vice-versa. Do not incur debts or take money out of the company to pay yourself unless the company has adequate funds to continue operating the business and paying debts as they become due. 12
Make sure that creditors and employees are paid before you are if the business is in financial difficulty or winding up. If the business is in financial difficulty or winding up, do not favor certain creditors over others, especially if those creditors are relatives, friends, or close business associates, or you have personally guaranteed payment to those creditors. Do not transfer business funds or assets to yourself or others without sufficient consideration. Consult your attorney or CPA before making any questionable transfers. If you decide to close your business and start a new one, don t just change the business name and continue in business as usual; structure the transition carefully with the assistance of an attorney to reduce the risk of successor liability claims. If you are buying a business, take care to assure that the debts of the seller are not assumed in the transaction. If you buy a business, do not continue to use the same name as the seller; do not use up the seller s stationery, business cards, or other indicia of operating under the old business entity name. Make sure that adequate consideration is paid for business assets and that payment is documented. Make sure the seller is solvent and able to pay its debts after the sale before committing to a sale of the business or its assets. If the seller is in bankruptcy or in receivership, attempt to structure the sale under 363 or RCW 7.60.260 to be free and clear of all liens and take additional steps to assure that notice is given and the order or plan provides protections against successor liability claims. If the seller is insolvent, the seller can make file bankruptcy or make an assignment for benefit of creditors and sell its assets through receivership under RCW 7.60; sales through bankruptcy or receivership are not automatically free of potential successor liability claims, so consult an attorney before committing to a business purchase or sale if insolvency is an issue. Recognize that asset sales and transactions between closely related persons (especially family members) will be more heavily scrutinized. Recognize that financial transactions occurring after a lawsuit is threatened or filed will be more heavily scrutinized. Recognize that fraudulent transfers or other actions taken with intent to hinder, delay or defraud creditors can result in personal liability of the owner and affect his ability to get a discharge if he has to file personal bankruptcy later. Conduct a periodic self-audit to assure that the business is observing formalities and not exposing the owners to personal liability; an attorney or CPA can be engaged to assist in the audit and point out potential red flags that require attention and correction. This should be done regularly, and long before any financial or debt issues arise. 13
As soon as the company is facing financial difficulties or creditor claims that threaten the company s viability, consult an attorney with experience with business debt issues, asset protection, and bankruptcy; the sooner you get legal advice, the more likely you will be able to avoid personal liability. -o0o- Copyright 2015 by Jeffrey L. Smoot. Published for informational purposes only, and may not be reproduced in whole or in part without the author s express written consent. This article should not be relied upon as legal advice. No attorney-client relationship is created or intended by publication of this article. If you desire legal advice or representation regarding the issues discussed in this article, please contact the author. 14