Back to where we started in part one: People who own and operate small businesses like to incorporate. The common perception is that by incorporating they will protect their homes and other assets from creditors if their businesses fail. Is their perception correct?
As we saw, corporations provide limited liability for their shareholders. If you own stock in a major corporation, and it loses a big lawsuit based on an injury caused by one of its products, the value of your stock might go down. However, the triumphant plaintiff can’t satisfy his judgment by taking your house. He can only take assets belonging to the corporation.
This principle is equally applicable to a small corporation, like the roofing business Bob started as a sole proprietor and incorporated after his first successful year. Unfortunately the roofing industry has recently encountered hard times. Bob’s company can’t pay its bills, and its tangible assets aren’t worth much, so Bob decides to shut it down and retire. He’s happy he incorporated, because he has limited liability for the company’s debts. He’ll just tell his lawyer to dissolve the corporation, take the cash in the checking account, and go play golf.
Bob’s lawyer has a few comments and questions. Bob is surprised to learn that dissolving the corporation might not be a good idea. A shareholder who receives a distribution upon dissolution is liable for the corporation’s debts to the extent of the distribution - there goes the cash in the checking account. Well says Bob, I’ll use it up paying some of the bills and then close the doors. Is that OK? Yes, but you’d better file the corporation’s last tax returns and pay whatever is due, or the Franchise Tax Board and the IRS may come knocking on your door.
That’s not so bad. No profit lately, so no taxes anyway. Bob is relieved. How much trade debt is there, asks the lawyer? That much? Really! You didn’t happen to sign the personal guarantees on your suppliers’ credit applications, did you? Bob’s been buying all his materials from the same wholesaler for ten years, and they’ve let him get way behind. He checks. Sure enough, he did sign that stuff at the bottom. ‘Didn’t pay much attention to it at the time. Oh, no! where did my limited liability go?
And what about the lease on the office and the yard, asks the lawyer. You didn’t personally guaranty that too, did you? Bob thinks hard. It happened a long time ago, but he finally remembers that the landlord refused to lease the place to the corporation without his personal guarantee. Oh, dear! Six months ago when he was still optimistic about the economy he let the lease automatically renew for another five years, so now he’s stuck for all that future rent! Bob starts to feel a little ill, but the lawyer has more questions.
How did Bob keep the books, including the corporation’s minute book? Did he always hold annual meetings and do minutes? Always pay himself a regular salary instead of using the corporation’s checking account like his personal piggy bank? Always sign all the checks, contracts, and invoices with the corporation’s name first, then his signature with the title President? Oops. Far from always. Bob discovers that legally instead of gaining limited liability, he may be the corporation’s alter ego, and therefore personally liable for all its debts, as if he’d never incorporated!
Wait a minute, says Bob hopefully. I’ll just have the corporation file bankruptcy! That’ll work, won’t it? Sorry, Bob. Corporations can file bankruptcy, but they can’t get discharged from their debts like real people.
Bob rushes off without saying goodbye. He’s learned that limiting liability by incorporating can be an illusion for a small business. He has to drum up some new work in a real hurry.
San Diego Business Attorney Stanley D. Prowse specializes in California Corporate Law. We are located in Carlsbad California and welcome your legal inquiries.