Artboardbusiness-litigationconstructionfamily-lawfinancefood-servicegeneral-litigationgovernmenthomepage_courthousehomepage_personhospitalityimmigrationinsuranceArtboardlabor-employment-lawmanufacturingmedianon-profit-organizationsphone_bluereal-estatetechnologytelecommunicationstransportationwholesale-retail-saleswills-trusts-estates

One of the principal motivations for operating a business as a corporation or a limited liability company (“LLC”) is that, by law,[1] doing so will generally shield the owners of the business from becoming personally responsible for most liabilities incurred by the business.  Thus, while a creditor of a corporation or an LLC can obtain a court order seizing assets owned by the company itself (such as the company’s inventory, equipment, accounts receivable and the cash in the company’s bank accounts) in order to satisfy a liability of the company to that creditor, creditors generally cannot seize assets that belong to the company’s owners (such as their homes and cars and the cash in their personal bank accounts).  In contrast, the owners of a company operated as a sole proprietorship or a general partnership do not have this protection, meaning that creditors of the business can potentially seize both the assets of the business and the owners’ personal assets to satisfy a liability of the business.  

From this point forward, for convenience, this article will use the term “company” to refer to both corporations and LLC’s.  

From what Liabilities are Owners Shielded?  

The liabilities of a company fall into two categories: (1) commercial liabilities; and (2) “tort” liabilities.  Commercial liabilities are debts that arise from business transactions, such as amounts owed for utilities, employee wages and benefits, office supplies, insurance premiums, and other typical business expenses, as well as the company’s rent obligations and loan repayment obligations.   

In contrast, tort liability refers to the legal liability that is imposed on a company for an injury or loss caused by the company’s negligence or other misconduct.   Note that, by law, a company is liable not only for its own negligence or misconduct, but also for the negligence or misconduct of the company’s employees while they are acting on behalf of the company.  Some examples of tort liability include a company’s liability for injuries sustained by a customer who slips on a loose rug in the company’s reception area, a traffic accident caused by an employee while driving to a customer’s office, an injury or loss sustained by a customer from the negligent design of a product manufactured by the company, or a loss sustained by a customer as a result of the company’s negligence in providing a service. 

Subject to the exceptions discussed below, the owners of a company are not personally liable for either the commercial liabilities or tort liabilities of the company, and their personal assets may not be seized to satisfy those liabilities.

To What Extent is an Owner’s Liability Limited?

 As noted above, the owners of a company are generally not personally liable for either the commercial liabilities or tort liabilities of the company, and their personal assets may not be seized to satisfy those liabilities.  However, there are a number of exceptions to this rule:

1. Personal guaranties.  Unfortunately for small business owners, most creditors weren’t born yesterday.  They are well-aware that people choose to operate their businesses as corporations or LLCs for the specific purpose of preventing the owners from being liable for amounts owed to the creditors.  As a result, sophisticated creditors – most notably banks and landlords – will almost always require the owner of a small business operating as a corporation or an LLC to sign a “personal guaranty.” By executing a personal guaranty, the owner is waiving her limited liability with respect to the company’s debt to that particular creditor and is agreeing that the creditor will have the right to seize her personal assets if necessary to obtain payment of that debt.  In situations where an owner is forced to sign a personal guaranty in connection with a specific transaction, the savvy owner will attempt to include language in the guaranty that limits either or both the maximum amount for which the owner will be personally liable under the guaranty, or the duration of the guaranty (such that, for example, the guaranty might expire after a year or two once the business has established a good credit history with the creditor).  Beware: Many unscrupulous vendors (including some credit card companies) conceal personal guaranties in the “fine print” of their customer agreements, stating that the person signing the form is expressly agreeing to be personally liable, along with the company, for all amounts owed to the creditor.

2. Negligence or misconduct by the owner.  Both the Indiana corporations statute and the Indiana LLC statute (cited in footnote 1) expressly provide that while an owner is not generally liable for the liabilities of the company, that limitation does not protect an owner from liability for the owner’s own acts or omissions.  For example, where the owner of an excavation business operating as an LLC personally operates a backhoe that ruptures a gas line and causes an explosion, the owner will be personally liable for the damage caused by the explosion, as will his LLC.  Note that the laws applicable to many professions also provide that a professional who operates his business in the form of a corporation or LLC may not limit his liability for his own acts and omissions. [2]  

3. Failure to identify as a corporation or an LLC.  A creditor dealing with a corporation or an LLC is presumed to know the law and is presumed to know that the owners of the company will not be personally liable for the debts of the company (unless the owners provide personal guaranties).  However, the owner of a company may have personal liability if the creditor is not aware that the company is a corporation or an LLC.  For this reason, it is imperative that all of a company’s contracts use the full name of the company (for example, “Acme Industries, LLC” not merely “Acme Industries”), and the person signing any company contract must specifically reference his position with the company as part of his signature (for example, “John Jones, President” or “John Jones, Manager,” and not merely “John Jones”).  It is also important that a company include its full name on its stationery, its business cards and its website to give customers and vendors notice of its status as a corporation or an LLC.

4. Personal liability imposed by statute.  There are various federal and state laws that specifically impose personal liability on a business owner (and other company officers) for certain liabilities.  For example, personal liability can be imposed for the failure to collect and remit payroll withholding taxes to the Internal Revenue Service.[3]  Additionally, owners may be personally liable for negligence or other misconduct relating to employee benefit plans that they control, such as where they collect but fail to remit employee contributions to a health insurance plan or 401(k) plan, or where they misuse or mismanage the assets of an employee retirement plan.[4]

5. “Piercing the corporate veil.”     There are certain circumstances where either the neglect or misconduct of the owners will result in a court concluding that a company’s status as a corporation or an LLC should simply be disregarded and that the owners should be personally liable for some or all of the liabilities of the company.  A court’s decision to disregard a company’s status as a corporation or an LLC is commonly referred to as “piercing the corporate veil.”  The Indiana courts have ruled that the corporate veil can be pierced and personal liability imposed on the owners where the creditor has proven that the owners have failed to treat the company as something separate from themselves, and their misuse of the company would constitute fraud or otherwise promote injustice.[5] Simply stated, if the company hasn’t been operated like a corporation or an LLC, the court may elect not to treat it as a corporation or an LLC.  Some of the specific factors the courts will examine when determining whether to pierce the corporate veil and impose personal liability on the owners include the following: (i) undercapitalization; (ii) the failure to maintain required business records; (iii) fraudulent representations by the owners, managers or directors; (iv) use of the company for fraudulent, illegal or unjust activities; (v) payment by the company of the owners’ personal obligations (for example, using the company checking account to pay the owners’ personal credit card bills); (vi) commingling of the assets and affairs of the company and its owners (for example, failing to maintain company bank accounts separate from the owners’ personal bank accounts); (vii) failure to observe the required formalities for the corporation or the LLC (for example, failing to hold required meetings or to take votes on matters requiring a vote); and (viii) other conduct “ignoring, controlling, or manipulating” the status of the company as a business separate from the owners.[6] 

6. Improper distributions to owners.  Both corporations[7] and limited liability companies[8] are prohibited by law from making distributions to their owners if, following the distribution: (i) the company would be unable to pay its debts when due; or (ii) the amount of the company’s liabilities would exceed the value of its assets.  If distributions are made to owners in violation of these rules, the owners will be subject to suit by creditors of the company to recoup the amount of these improper distributions.  In the case of a company’s bankruptcy, the bankruptcy laws will also allow these improper distributions to be recouped by the bankruptcy estate.  Note that in the case of improper distributions, the owners are not actually being held personally liable for a debt of the corporation.  Rather, the owners are simply being required to give up the distributions that should not have been made to them.

Conclusion.

The ultimate decision as to whether or at what point a small business would genuinely benefit from the limited liability afforded by a corporation or an LLC necessarily rests upon the owners’ assessment as to what potential liabilities the company has, and the extent to which the creation of a corporation or an LLC would actually insulate the owners from personal responsibility for those particular liabilities.  These are some relevant considerations –

  • A business that has a high volume of customer/client traffic in and out of its place of business (such as would be the case with a retail establishment), has a much greater risk that a customer may sustain a personal injury than would a consulting business with few on-site customer visits, such that the owner of the retail establishment would be much more likely to benefit from the limited liability afforded by a corporation or an LLC.
  • The more employees a business has, and/or the more owners who are actively involved in the business, the greater its risk that one of these employees or other owners could create a liability for the company.  As a result, there is a much greater likelihood that an owner would benefit from the limited liability afforded by a corporation or an LLC with respect to the negligence or other misconduct of these employees or one of the other owners.  This is especially the case if the employees or other owners will be operating vehicles or engaging in other high-risk activities on behalf of the business.
  •  The owner of any business that manufactures or sells a product that could potentially cause its customers to sustain personal injuries or incur financial losses would benefit from the limited liability afforded by a corporation or an LLC.
  •  Every business owner will likely benefit to some degree from the limited liability afforded by a corporation or an LLC with respect to contractual liabilities.  The extent of that benefit would depend upon the extent to which the business owner could avoid having to provide personal guaranties to vendors and other creditors of the business.  However, many vendors do not require personal guaranties, which means that if the business fails, the owners will have no personal liability for the debts owed to those vendors.
  •  The creation of a corporation or an LLC will not insulate the owners of the business from liability for their own actions.  Thus, for example, in the case of a consultant in business by himself, the creation of a corporation or an LLC would do nothing to protect the consultant from claims resulting from him having provided bad advice.

PRINT ARTICLE

The experienced attorneys of Riley Bennett Egloff, LLP are available to further explain the advantages and limitations of corporations, limited liability companies and other forms of business entities, and to assist business owners in choosing the most appropriate form of entity for their respective businesses.

[1] Indiana Code §23-1-26-3(b) limits the liability of shareholders in a corporation, and Indiana Code §23-18-3-3(a) limits the liability of owners of an LLC.   

[2] See, e.g., Indiana Admission and Discipline Rule 27 (applicable to attorneys), and Indiana Code §23-1.5-2-6 (applicable to all professional corporations).

[3] Internal Revenue Code §6672(a).

[4] 29 U.S. Code §1109

[5] See Aronson v. Price, 644 N.E.2d 864, 867 (Ind. 1994).

[6] Id.

[7] Indiana Code §23-1-28-3

[8] Indiana Code §23-18-5-6

 


© Riley Bennett Egloff LLP

Disclaimer: Article is made available for educational purposes only and is not intended as legal advice. If you have questions about any matters in this article, please contact the author directly.

Permissions: You are permitted to reproduce this material in any format, provided that you do not alter the content in any way and do not charge a fee beyond the cost of reproduction. Please include the following statement on any distributed copy:  “By John L. Egloff© Riley Bennett Egloff LLP - Indianapolis, Indiana. www.rbelaw.com