Personal Liability Risk Despite Incorporation | Lowenstein Sandler LLP

Today’s Advocate General – January 2022

One of the fundamental principles of corporate law is that the owners, directors and officers of a legal person are generally not personally liable for the debts of the entity. Without this protection against personal liability, individuals would be deterred from taking risks. However, there are circumstances in which this corporate shield is threatened – sometimes due to legal or other exceptions, but often due to poor decisions and lack of management oversight. These pitfalls are particularly common in small and medium-sized businesses and family businesses, where the lines between individuals and business can be blurred.

When business is profitable and bills are paid on time, these problems rarely occur. but when a company faces financial difficulties, creditors begin to seek other sources of recovery – owners, officers, directors and related parties. Below are examples of areas where business owners and directors can be held personally liable for business debts.

Government entities often impose personal liability on “controlling persons” when certain “trust fund” taxes remain unpaid.

Liability of Directors and Officers

Claims against officers and directors have become common in bankruptcy cases. Claims for breach of fiduciary duty are the most common, but other claims such as claims for illegal stock buybacks or dividend payments may also be asserted.

Taxes on trust funds

Government entities often impose personal liability on “controlling persons” when certain “trust fund” taxes (sales taxes or payroll withholdings) remain unpaid. Therefore, potential controlling persons – directors, officers, anyone with check signing authority – must ensure that these obligations are delivered in a timely manner.

Real estate

When a debtor company leases the property on which it operates to an entity owned by its shareholders or related persons, creditors examine the bona fides of the transaction – whether it is a real lease, a disguised sale or a secure transaction; whether the lessor is the de facto owner of the property (especially where the lessor has paid the mortgage or other expenses usually paid by owners); and/or if the conditions were in line with market conditions.

Credit card

Use of the company’s corporate credit card in resort areas, on excessive airfares or luxury hotels, or at certain merchants, are signs that the executive may be abusing his privilege. Creditors can conduct a forensic investigation and attempt to have these items repaid or qualify as taxable income.

Loans in lieu of pay

Providing executive loans instead of paychecks reduces company expenses, improves the income statement, and creates an additional asset on the balance sheet in the form of a loan receivable. However, such loans may be considered tax-free income, and creditors may challenge this practice as artificially inflating a debtor’s financial position to induce creditors to extend credit or other benefits to the business. In the event of bankruptcy, creditors may attempt to characterize these insider loans as capital injections, and the debtor company may be forced to pursue repayment of the loans.

Pay but no work

Payments made to a family member who is not actually working may be recovered as a fraudulent transfer because no value was received by the business in exchange for the payment.

Free Work and Employment and Retirement Income Security Act (ERISA)

Applicable laws may impose personal liability on owners/directors who fail to pay employees for their services. In addition, ERISA Trustees may be held personally liable for losses incurred by the Plan resulting from any breach of fiduciary duties imposed under ERISA related to the administration of ERISA Plans.

Financial statements and financial statements to induce credit (e.g. credit fraud)

A borrower’s principal who knowingly and intentionally falsifies the borrower’s financial statements in order to facilitate credit extensions from a lender may be held personally liable for the bank indebtedness and face potential fraud claims. Similarly, if a person knowingly makes false or misleading statements about the company’s financial condition to obtain credit from a vendor, that person may be subject to personal liability.

Ultimately, personal liability is often sought when insolvency forces creditors and investors to seek sources of recovery. Owners, directors and officers would be wise to take legal steps that protect their assets in such circumstances.

Reprinted with permission from the January 2022 issue of Today’s Advocate General. © 2022 Today’s Advocate General. All rights reserved.

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