In a previous article on protecting your assets (Part 1), I wrote about the importance of maintaining corporate formalities. Businesses that commingle assets, forgo record keeping, official minutes, and fail to keep their registration with the State of Michigan up to date risk losing their corporate protections. In most cases, the corporate form limits your personal liability and insulates your personal assets from business debt – unless a creditor successfully argues that the corporate form is a sham and used to perpetuate fraud. However, this protection is not an absolute and there are many situations where that protection may be set aside and personal assets (the owner’s house, boat, car, bank account, etc.) are at risk.
Even if you run a perfectly organized business with current paperwork and a separate bank account, there are still situations where you are at risk of personal liability for your business debts. The following three scenarios are most common:
- Did you sign a personal guaranty for a business lease or a business loan? Personal guaranties (or guarantys) are additional collateral that you may be asked to execute as a prerequisite to a business loan or even a business lease. A personal guaranty is effectively an agreement that waives your corporate protection and allows a creditor to go after your personal assets directly. Because a small business does not have many assets to collateralize a loan or assure a landlord that obligations will be paid, you may be asked to sign the personal guaranty. Whether you accept that risk is up to you, but at a minimum you should read the document carefully and discuss it with your attorney so that you understand the implications. You may also be able to negotiate for a lease or loan without a personal guaranty, but in most cases you will need to provide sufficient collateral or other assurances to secure your obligations.
- Are you knowingly breaching a contact or a lease? Some business owners erroneously assume that because they have an LLC, they can ignore contracts or leases. For example, if your company signed a 3-year lease in a dying shopping center – what’s to stop the LLC from defaulting on the lease and walking away? A lawsuit can only reach the LLC, right? That’s not only wrong, but it is also a dangerous line of thinking that may put your personal assets at risk. A court will not allow the abuse of the corporate form to evade obligations or escape debts. Understand that corporations are created by statute – i.e. the law – to facilitate business. At the same time, the court system will not apply the law to facilitate a party’s evasion of its contractual obligations. If you are abusing the LLC to default on loans, other contracts, or lease obligations, a court may very well determine that you are abusing the system, pierce the corporate veil, and impose personal liability.
- Are you moving assets around to another company? You may also think that you can simply start over by forming a new LLC, transferring the assets of the old LLC to the new one, and leave the loans, contracts, and leases behind with the old shell of a company. But even if you declare bankruptcy for the old LLC, your assets are not immune from creditors. The bankruptcy proceedings allow aggrieved creditors to challenge any transfers made before bankruptcy as “fraudulent” and have them set aside for the creditor’s benefits. And even if your old business had no assets, a court may still impose personal liability and pierce the corporate veil if it is determined that your actions were for a fraudulent purpose – such as escaping a debt, contract, or lease obligation.