Q: How can business owners protect their personal assets and avoid personal liability for claims arising from the operation of their business?
1. Utilize a business entity which provides for limited liability of owners and operators.
Persons conducting a business as a sole proprietor or general partnership (i.e., without any corporate entity) have unlimited personal liability for debts and other obligations of the business. A sole proprietorship is a business for which the assets used by the business are owned individually by the proprietor. Likewise, contracts of a sole proprietorship are executed by the proprietor in his individual capacity rather than as agent for a separate business entity. Not only are the sums invested in the sole proprietorship business at risk, but all other assets of the proprietor are subject to claims against the business as well. For example, if the business is found liable for breach of a contract with a customer, a judgment will likely be entered against the owner for personal liability, subject to satisfaction from both assets used in the business as well as any of his or her other non-exempt assets. Also, partners in a general partnership are each jointly and severally liable for all debts of the partnership. Unlike a limited partnership, all partners in a general partnership have full liability. Absent agreement to the contrary, each partner of a general partnership has authority to contract on behalf of the partnership.
By contrast, owners doing business as corporations, limited liability companies or limited partnerships are generally not personally liable for the debts, obligations or liabilities of the business, including liabilities under a court judgment, decree or order. See e.g., Texas Bus. Org. Code §§21.223 (corporation) and §101.114 (limited liability company). If properly formed, the business is a separate legal entity with all the powers of a natural person. Only assets owned by the business are subject to execution to satisfy a judgment for debt or liability of the entity. The business owns only assets needed for successful operations.The business entity must be formed in accordance with state law and all required filing fees must be paid. Issuance of a certificate of creation for the entity by the Texas Secretary of State is considered proof of its legal existence.
For discussion regarding of the type of entity which will best serve your needs, see our chart on Business Entity Types.
2. Adequately capitalize the business.
No business should commence operation without capital sufficient to sustain operations, meet liabilities and provide a reserve for contingencies. In order to do so, the entity must at a minimum collect the initial capital contributions pledged to be made by shareholders of a corporation, members of a limited liability company or partners of a limited partnership. Copies of checks, wire transfers or other means of payment should be retained as proof of such contributions. Secondly, in the event of depletion of initial capital or increased expenses or liabilities, the entity may need to secure additional capital to continue or expand operations and meet financial obligations. Additional capital may be raised from new investors or further contributions from existing owners.
If a business operates without adequate capitalization, the business owners and operators could later be held personally liable for claims against the business. An entity which lacks adequate capitalization to pay claims may be considered merely an “alter ego” for the individual owners or operators. The business entity is viewed as merely a sham to protect the owners from their wrongful or negligent conduct. Collection of capital contributions pledged by owners (shareholders of a corporation, members of an LLC or partners in a partnership) counters such allegations.
3. Avoid commingling of business and personal assets.
- Maintain separate bank accounts. It is essential that funds paid or received on behalf of the business be segregated from personal funds. A separate bank account is therefore required.
- Keep timely and accurate records of all transactions between business owners and the business, including loan advances and prepayments, capital contributions whether in the form of cash, donated property or services rendered. Properly authorize and document corporate transactions affecting the capital structure of the business. If additional funds are received after commencement of business, document the nature of the consideration received, i.e. sale of an interest in the company, loans, or cancellation of any stock or other interest.
4. Pay all taxes and file required tax reports.
- Tax payments and reports.The entity must pay all franchise, payroll and federal income taxes AND file all required tax reports on a timely basis. State law requires franchise tax reports and public information reports to be filed even when the business entity is inactive or no tax is due. A company’s initial report is due 1 year and 89 days after the company’s “beginning date” in Texas. The “beginning date” is the date that the company charter takes effect, generally the date of issuance by the Secretary of State. In subsequent years, the reports are due on May 15. The public information report lists the names and addresses of all officers and directors of corporations, and all members of limited liability companies.
- Forfeiture of charter and personal liablityIf the franchise tax reports are not filed or franchise taxes are not paid, then the Texas Comptroller of Public Accounts may forfeit the company charter. In the event of forfeiture, the entity is denied the right to sue or defend in a court of the state of Texas. More importantly, as provided by Section 171.255 of the Tax Code, forfeiture of a charter means the liability of a director, officer, or member/manager of a corporation or LLC has personal liability as if he or she were a partner and the corporation or LLC were a partnership. The personal obligation does not apply in the event the debt of the entity was created over the officer’s or director’s objection.
The Texas statutes provide that mere failure to follow corporate formalities should not in itself be cause for imposing personal liability on a business owner or operator for a debt or obligation of the corporation. However, the Texas courts in some instances indicate failure to maintain the separate identify of the corporation or limited liability company can be a factor in imposing personal liability. Accordingly, it is advisable to follow and document all corporate procedures carefully, including keeping up-to-date Articles of Creation, also known as Articles of Incorporation and Bylaws, adhering to procedural requirements of the Articles and Bylaws, issuing all stock certificates on a timely basis and recording the issuance in a stock ledger, holding regular shareholder and director’s meetings or document all decisions or shareholders and directors by a consent in lieu of meetings. All extraordinary corporate transactions, such as loans, sales of assets, major purchases and mergers or acquisitions should be approved and the decision documented in a corporate minute book. All documents executed on behalf of the corporation should reflect that the signer acted in a representative capacity for the entity. A separate bank account should be maintained for the entity and personal funds always maintained in separate accounts. Likewise, corporate funds should never be even temporarily deposited in personal accounts. Personal expenses or purchases should not be paid or reimbursed by the corporation without a clear policy statement that such transactions are authorized compensation for services rendered.
5. Maintain adequate insurance coverage.
Even following the above guidelines, proper insurance coverage is still a must. Doing business by means of a corporate entity only protects the owners from claims arising out of contracts of the business. A business owner, operator or employee is still liable for his or her personal negligent conduct that causes injury to third parties. Moreover, the business may in turn held liable for that conduct if committed in the scope of employment.
For example, the business owner who negligently operates a company vehicle so as to cause an accident injuring another driver is personally liable. His or her non-exempt personal assets could be seized to satisfy any judgment for recovery of such damages. If the owner was operating the vehicle for a business purpose, then the business is also liable for his negligence under the doctrine of respondeat superior. If an insurance policy covering the acts of business owners and employees is in effect at the time of the accident, claims for damages will be paid or defended by the insurance company so that personal assets should not be used to pay the cost.
Contact Mr. Hemphill to schedule an appointment to discuss how we can assist you with your legal matters.
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