Owner Actions that Can Result in Personal Liability

One of the reasons you incorporate or form a limited liability company is to protect yourself against personal liability. And, for the most part, such protection is effective. However, there are actions you might take innocently or not so innocently, that could jeopardize the position of safety. At the top of the list is:

• Corporations acting as sole proprietorships or as alter egos of another person or legal entity.
• Preferential treatment of creditors, stockholders or insiders.
• Nonpayment of taxes due the IRS and state agencies.
• Improper actions or self-dealing, e.g. personal transactions with the business that antagonize or alienate minority stockholders and lead to lawsuits.
  

These are the types of actions that can make you personally liable and your corporate form of business might not protect you. Such actions could let an angry customer or supplier or minority stockholder (in lawyer jargon) pierce your corporate veil and sue you personally. There’s an additional risk … if you don’t observe the formalities of being a corporation, the IRS can disregard your corporate status and treat the stockholders as individuals for income tax purposes as well as liability purposes.

Corporate Actions
In general, shareholders cannot sue management or directors personally for errors that cause corporate injury as long as the errors were made in good faith. If, however, it can be shown that management acted with gross negligence or fraudulently, the situation changes. Here’s a list of actions that could make you personally liable:

• You violate your fiduciary position as an officer of the corporation, a board member, or trustee of your company’s retirement plan.
• You use "inside" information to personally profit to the expense or detriment of the corporation.
• You knowingly distribute misleading or fraudulent financial statements, reports or tax returns.
• Even though you know an action is illegal, you allow it to occur injuring the company financially.
• You fail to make sure that the corporation pays payroll taxes due to the IRS or states in which you operate.
• You take some action, of fail to act, in a manner, that constitutes gross negligence (i.e. recklessly or with complete disregard) and the company suffers.
• You don’t file required statements or reports, such as state sales reports.
  
  

What to Do
In each of these cases, the precaution is to act responsibly and in good faith. When a transaction is questionable, get your lawyer’s opinion before finalizing it. If you must rely on information from another member of management in making a decision or taking an action, take reasonable and basic steps to ensure that the information is accurate and complete. This is particularly important for board members.

Your Creditors
Once again, the major issue is good faith. If a creditor suspects some sort of chicanery in an effort to avoid paying corporate debt, the courts may allow the creditor to reach into management’s personal pockets. Here are some actions that are almost certain to attract attention or raise suspicions:

• In anticipation of bankruptcy, you divert corporate funds to avoid paying creditors or you unjustly pay certain creditors ahead of others (referred to as preferential treatment).
• The company compensates its officers and/or directors so excessively that corporate assets are depleted, thus cheating creditors of what they are owed.
• Shareholders receive dividends while the company is in serious financial trouble, thus harming the creditors.
• Employees are left with wages owed to them after you dissolve the business.
• You fail to properly fund the pension/retirement plan
  

Six Ways to Protect Yourself

1) Perform the required corporate formalities such as shareholder and directors meetings, vote on items that require voting, corporate books and minutes, etc.
2) Before entering into an agreement, which could materially affect the business, do your homework and leave evidence that you did so. Prepare reports and memoranda, which support your decision to enter into the transaction. A simple example would be the preparation of cash flow projections to support a term loan.
3) When you have to sign a contract, sign it as an officer of the company and not as an individual. (See accompanying article titled "Corporate Signatures and Signature Bars.")
4) Make sure the word "Inc.," "Corporation," "Ltd." or "LLC," for example, appears after the name of the company.
5) If your business is controlled by you or your family, try to have at least one outside or independent board member.
6) If you are a board member, keep current on corporate affairs. Read the minutes of the board meetings and ask questions about actions you donÕt understand. If you canÕt attend the meetings regularly, resign rather than run the risk of personal liability.
7) Before affecting any business transactions with yourself or your family members, see the cautions in the accompanying article "Cautions on Transactions Between You, Your Family and Your Business" in this issue of TBO.

Lastly, owners should keep their personal affairs separate from corporate affairs. This sounds obvious, but often strong-willed business owners present the image of themselves that says, in effect, "I am the corporation." If that's the image you want to convey, then you better be prepared to assume the risk.

This article was written by David L. Perkins, Jr. He is a VERCOR partner, M&A Consultant, business appraiser and editor and publisher of the national newsletter titled The Business Owner.