One of the most effective ways to protect a business owner's personal assets is to operate the business through a corporation, LLC, limited partnership, or other limited liability entity (“LLE”). LLEs are considered “persons” under the law, which means that they can own property, enter into contracts, incur liabilities, sue and be sued, and even be prosecuted for crimes. Generally, owners of an LLE have no personal liability for the entity's obligations. The creditor's sole recourse is against the LLE and its assets. For the most part, the various types of LLEs provide the same level of protection against personal liability. In other words, an LLC will not insulate an owner's personal assets any better than a corporation, or vice versa.
Other business owners, however, have the opposite concern. They worry that the personal creditors of a partner can attach the partner's interest thereby enabling them to interfere with company management or force the sale of company assets. This is where the type of LLE you select can make a critical difference. For the reasons discussed in the second part of this article, we believe the LLC is the best choice of entity for protecting the business assets from members' personal creditors.
Piercing the Corporate Veil -- Myth or Reality?
There is a perception among some business owners that creditors of the business can "pierce the corporate veil" and sue the owners personally. In our experience, this is more of a myth than a reality. In fact, it is very difficult to pierce the veil of a Maryland LLE. Maryland courts have even described veil piercing as a "herculean task." Basically, if an LLE has been validly formed in Maryland and in good standing, a court will only disregard the entity status if necessary to prevent fraud or to enforce a paramount equity. In contrast to some other jurisdictions, a court will not allow personal recourse against owners of a Maryland LLE merely because organizational formalities are neglected (e.g., annual meetings), or the entity is thinly capitalized, or the entity is merely the alter ego of its sole owner. While these are factors a Maryland court may consider, they are not sufficient reason to pierce the veil of a duly formed Maryland entity.
There are, however, several circumstances in which creditors can sneak past the entity veil and pursue the owners personally.
First, if the entity name has not been used properly, creditors may believe they are transacting business with a sole proprietorship or a general partnership, which are entity structures that do not insulate owners from liability; if this occurs, the creditor can potentially pursue the business owner. A common mistake is for business owners to sign contracts in their individual names or under a trade name that is different from the entity's precise legal name. For example, if the company's name is Big & Bad Technologies, Inc., it is not sufficient to sign a contract in the trade name of "BBT," even if that is the name used in marketing materials. In signing documents, the entity's legal name should always be used, and any document signed on the entity's behalf should be signed by an officer or other agent (e.g., president, vice president, managing member, etc.) identified by title in the document. For example, a contract would be signed on behalf of the corporation as follows:
Big & Bad Technologies, Inc.
Cy Strung, President
The entity name should also appear on letterhead, envelopes, business cards, websites, invoices, purchase orders, receipts, and other materials. All telephone listings should also include the entity name. If a trade name or DBA is used, a Trade Name Application should be filed with the Maryland State Department of Assessments and Taxation (SDAT). The Trade Name Application should designate the LLE as the owner of the trade name. (For example, Big & Bad Technologies, Inc. would be the owner of the "BBT" trade name.) With a proper trade name filing, if the company does incur liabilities under its trade name, at least an argument can be made that creditors were on record notice they were transacting business with an LLE that owned the name.
Second, owners may also be personally liable for failure to pay state and federal employment withholding taxes and state sales taxes. Withholding tax liability is imposed on the theory that withheld employment taxes are held in trust by the individuals who were in a position to decide whether or not to pay them (so-called "responsible persons"). By statute, certain corporate officers are automatically liable for uncollected or unpaid Maryland sales, use, and admission and amusement taxes. Of course, if the LLE is a pass-through entity for tax purposes (e.g., an "S" corporation, LLC or partnership), the owners are personally liable for income taxes.
Third, an LLE may not insulate its owners from professional liability and from certain tort actions (e.g. suits for negligence or other wrongful or illegal conduct). For example, a cab driver who hits a pedestrian will not escape personal liability because the cab was owned by his corporation. If that were the case, we'd all incorporate our cars! Proper insurance coverage can provide protection from personal liability where the entity fails. (In the last example, the cab driver would have been protected with a proper automobile policy.) Before starting a new business, one should almost always obtain adequate general liability insurance coverage with a reputable carrier. Other types of liability insurance may also be appropriate, such as errors and omissions, motor vehicle and directors and officers (D&O) liability insurance. Often liability insurance will provide protection in cases where the corporate entity protection falls short.
Fourth, owners may be liable for acts or omissions committed by them personally which are alleged to be fraudulent or illegal. As discussed above, fraud is one of the few grounds for piercing the entity veil.
Fifth, if owners receive dividends or profit distributions from an LLE while the entity is insolvent and facing actual or threatened law suits or investigations, creditors may be able to sue the owners to recover those distributed funds. Such distributions would be considered fraudulent conveyances.
Sixth, LLE owners owe certain duties to the other owners. Directors of a corporation, for example, owe a duty of loyalty which requires them to act in good faith and in best interests of the entity. Similarly, members of an LLC and partners of a partnership owe a fiduciary duty to their fellow owners. An owner who violates these duties may face personal liability to other owners. Depending on the situation, it may be worthwhile to purchase directors and officers (D&O) liability insurance providing coverage against stockholder suits.
Finally, and perhaps most obviously, the LLE must actually exist in order to insulate owners from liability. From time to time, we encounter a business using an LLE suffix in its name (e.g., Inc., LLC, LLP, P.A, etc.), but it turns out the entity was never actually created by filing formation documents with the State. In that case, there is little argument that the business owners are not personally liable for business obligations. (Not to mention the fact that they may be committing a misdemeanor.)
Assuming the LLE was properly formed, it is important the entity remain in good standing by filing annual reports with the state (in Maryland, the Personal Property Tax returns). If a filing is missed, the LLE will forfeit its charter and cease being a legal entity. Remember on Star Trek when Captain Kirk barked orders to the always overworked and underappreciated Scotty to put up the shield? And remember how, even though Scotty could always squeeze out "jist a wee bit marh" juice, the shield always threatened to fail under intense bombardment from some never-before-encountered super alien weapon? Well, happily, it is a lot less challenging to keep the entity shield in place. And, if the entity's charter does lapse, the state is very forgiving. One simply has to file articles of reinstatement with the necessary back taxes and penalties, and the entity's forfeited existence will reinstated retroactively.
The bottom line is that, with some good planning and common sense, together with adequate liability insurance coverage, an owner should be able to obtain some fairly reasonable protection from personal liability for business obligations. Be aware, however, that there are always risks in business, and you can never eliminate the risk of personal liability altogether.
Protecting Company Assets from Owners' Liabilities
Now we consider the opposite challenge, protecting the assets and operations of the entity from claims of an owner's personal creditors. Let's assume the following set of facts:
Big & Bad Technologies, Inc. has three stockholders who own a total of 100 shares: Cy Strung (60 shares); Nur Rotic (20 shares); and Abby Normal (20 shares). Collectively, the stockholders constitute the corporation's three-member board of directors. Cy Strung has a bad auto accident involving serious personal injuries, for which he is clearly at fault. Unfortunately, Cy is not adequately insured, and the plaintiff wins a sizable judgment against him. Eventually, through the judicial process, the injured plaintiff seizes Cy's BBT stock. Because the plaintiff owns 60% of BBT's shares, the plaintiff has the necessary stockholder votes to replace all the corporation's directors. The plaintiff promptly removes Cy, Nur and Abby from the board and appoints himself and two family members as directors, thereby assuming total control of the corporation. The board promptly fires Cy, Nur and Abby as employees, and hire themselves as the new management team.
This is a grotesque example, but it graphically depicts how a stockholder's judgment creditors can seize the stockholder's shares and thereby virtually step into his or her shoes as an owner. Exploiting this opportunity, the plaintiff in our example actually became a substitute stockholder, voting Cy's shares to seize control of the business. Even if the plaintiff did not have the required votes to remove directors, the remaining stockholders, by virtue of their role as directors, would owe fiduciary duties to the plaintiff stockholder. The plaintiff would also have stockholder rights to inspect confidential books and records of the corporation. And, depending on the circumstances, the plaintiff may also have the right to seek involuntary dissolution or receivership of the company.
Now, assume the same facts except that Big & Bad Technologies had been formed as a limited liability company (LLC) rather than a corporation. Under the Maryland Limited Liability Company Act, the injured plaintiff in the above example could only have enforced the judgment by imposing a “charging order” against Cy's membership interest. A charging order is a court order requiring the LLC to pay the plaintiff the debtor member's share of LLC distributions. In this respect, a charging order is akin to a wage garnishment, except it is against the member's distributions rather than wages. The charging order would not, however, give the plaintiff the right to seize the member's interest.
The reason for this result is the limited transferability of LLC membership interests. Under the LLC Act, a transferee of an LLC interest (including a judgment creditor of a member), is only entitled to receive payment of the transferring member's LLC distributions. The transferee cannot attach the member's interest or be admitted as a voting member. Consequently, the transferee does not have the right to participate in company management, to act on behalf of the company, to inspect company books, or to force an involuntary dissolution. In contrast, because corporate stock is freely transferable, a creditor who attaches a debtor stockholder's shares assumes all of the rights of a stockholder, absent contrary provisions in a well-drafted buy-sell agreement.
To sustain this favorable result and preserve LLC assets, the company's operating agreement should not permit transferees of a member's interest to be admitted automatically as full voting members. The operating agreement should make clear that transferees of a membership interest only have the right to receive distributions but that they will not to be admitted as members without a unanimous membership vote. It may also be prudent to allow the company to repurchase a member's interest for a discounted value in the event of the member's personal bankruptcy. If a creditor does obtain a charging order, the creditor's rights can be limited by making profit distributions discretionary rather than mandatory, or by restricting distributions to insolvent members. A provision requiring quarterly or annual profit distributions will guaranty creditors a steady income stream from the company.
Finally, because the LLC may elect to be treated as a partnership, S corporation or corporation, choosing the LLC form of entity should be virtually a tax-neutral proposition.
Savvy lenders know that LLC interests make lousy collateral. For the same reason, the LLC is the optimal form of entity for protecting company assets from owners' personal creditors. We are urging clients concerned with protecting personal and business assets to consider the LLC as their choice of entity.
For more information on this article or any other business related matter, please contact an attorney in our Business & Transactional practice area.