Incorporating Not a Panacea
One of the most common misconceptions I run across is the mistaken belief that forming a corporation, limited liability company or limited partnership is a cure all in terms of protection from liability. Don’t get me wrong – forming an entity is a worthwhile endeavor and offers a great deal of legal protection. But there are exceptions that are all too often overlooked.
The first misunderstanding has to do with debt. Assume that your corporation borrows money and your bank requests that you guaranty that debt. Your personal guaranty means that, separate and apart from the corporation, you are liable for that debt if the corporation fails to pay. Likewise, some suppliers may require you, individually and not as an officer of your corporation, to personally sign for goods or services (yep – that’s a debt too). Again, your signature means that you are now personally liable to that supplier if the corporation doesn’t pay. The savvy business person carefully reviews contracts and the like in order to understand the repercussions of every signature. Although it’s not always feasible, quite often even what appear to be pre-printed contracts can be quickly modified to eliminate the need for a personal signature.
In a similar vein, anything you “invest” in your corporation is at risk. If you operate a construction company and invest some of your own personal tools in the company, those tools are now available to satisfy creditors. With real estate, this is why many people own real estate in one entity and then lease it to the operating entity – especially if there’s any appreciable equity in the real property.
Another form of corporate liability that can attach to a shareholder or key employee relates to “trust fund taxes.” The most common “trust fund” taxes are withheld from employees. Income tax, Social Security and Medicare taxes are withheld from the employee’s paycheck. The Internal Revenue Service and state agencies view these funds as the employee’s money (not the employer’s) that the employer holds “in trust” on behalf of the employee for payment to the IRS and state agencies. The employee receives credit for paying these taxes even if the employer does not pay the withheld funds over to the IRS or state agencies. In addition, certain sales taxes may also be considered trust fund taxes.
The problem usually stems from a business suffering cash flow problems. It is tempting for an employer to “borrow” money from such “trust accounts” in order to meet more immediate debts and obligations. In the current economy, the money in the employer’s trust account may well be its only liquid assets. When the business fails to turn around and the employer is unable to replace the funds, the employer (and other responsible persons) can be held personally liable for payment of these trust taxes.
The definition of a responsible person is not limited to just shareholders. “Responsible persons” are those who are in charge of and have the authority to decide which creditors to pay (including the IRS or a state agency). These people may include those who sign tax returns (or other related IRS or state filings), sign or possess the authority to sign checks, and those who make financial decisions. Typically, responsible persons include directors, officers, shareholders, members, managers, bookkeepers and individuals named on the employer’s bank account signature card. Responsible persons do not include people with no actual authority. For example, a bookkeeper who is authorized to prepare and sign checks, but does not have the actual authority to send the checks without prior approval may not be a responsible person for trust fund liability purposes. Simply put, a corporation offers no protection from this type of liability – which almost certainly will include substantial penalties and interest.
Failing to “observe corporate formalities” or disregarding an entity can also lead to personal liability. For example, not having annual meetings with the proper documentation may mean that you will become personally liable for corporate debts. Likewise, if you pay your mortgage and groceries with corporate funds a court may find that you have disregarded the corporation and, as such, may allow the corporation’s creditors to reach your personal assets. If you treat your entity as a sham, the law will likely disregard it as well. Use common sense and, if perplexed, contact your lawyer or accountant.
Finally, personal liability can attach to those who improperly dissolve their entity. This can happen inadvertently if the entity is not kept current with the Illinois Secretary of State in which event it is administratively dissolved. Until such time as the entity is reinstated (which involves a substantial penalty) there is no “corporate” protection and the likelihood is that all liability will become personal liability. Alternatively, sometimes it’s a conscious decision to terminate a corporation. In that event, the law dictates that a plan of dissolution must be followed. Typically speaking, that involves notifying all known creditors followed by an orderly liquidation of corporate assets to satisfy those creditors. Failure to follow the law, especially if corporate assets go into your pockets rather than your creditors, means that you will probably be found personally liable.
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