Business Entity Liability Protection and Keeping It

In previous blog articles, I have discussed measures outdoor recreation and adventure companies can properly maintain their business and activities to not only protect their clientele, but also their business, and personal assets (here and here).  Here, I will discuss how proper management of one’s business entity itself can further insulate the business and business owner(s) from potential liability.  LLCs and corporations provide their owners and shareholders limited liability protections through business entity formation, structure, and proper use and maintenance.  This means that the business’s liability, if it owes money or faces a lawsuit, is limited to the assets of the business itself.  Conversely, creditors and plaintiffs usually can’t reach the personal assets of the LLC’s or corporation’s owners and shareholders.  Because of this valuable legal shield, which is created when one forms and uses the business entity, a business’s creditors generally can seek payment only out of the business’s assets, including those invested by the owner(s)/shareholders.

The foundation of this limited liability protection is the business entity structure, which needs to be maintained and held be in good standing with the respective secretary of state to ensure such protections are in place.  “Good standing” is a place from which a business owner wants (or should want) to operate.  When it comes to LLCs and corporations good standing is also a legal requirement. And the consequences of not being in good standing, while unappreciated by many, can be devastating.

While starting a business entity can seem relatively simple (with the hiring of a lawyer and filing of application documents and fees), business owners often don’t realize the importance of proper maintenance of that entity (Annual Reports, Taxes and Fees, and proper management of accounts, insurance, and contracts) in order to actually reserve and have available the protections of that formed entity.  Maintaining a business entity’s “good standing” status with the Office of the Secretary of State prevents fines, penalties, filing delays and the additional compliance costs required to reinstate the entity.  There are also numerous other reasons for keeping business entities in good standing.

Most importantly, when a business is in not in good standing, the business owner may lose the personal liability protection of the LLC or corporation.  Entities that are not in good standing may also be unable to:

  • qualify to do business in another state;
  • enforce contracts;
  • bring or defend a lawsuit;
  • file certificates of amendment, merger or dissolution;
  • in some states, obtain business or professional licenses;
  • secure financing or open bank accounts; and
  • sell the business!

This is a long and scary list, which not only shows the value of a business entity structure, but also the extreme uselessness of it if not maintained properly.

The most common reason a company falls out of Good Standing is because the required Annual Reports have not been not filed and/or related annual fees paid.  Every corporation and LLC is required to file an Annual Report with the respective Secretary of State.  Additionally, if one fails to file a number of consecutive Annual Reports, per a state’s rules, a business could be administratively dissolved.  In some cases an owner could then lose the business name as well.   If administrative dissolution occurs, one would have to file reinstatement paperwork and pay costs, including fees and fines, to bring the business up to date and back in good standing.  Depending on the situation, the fees for reinstatement of a company may be more expensive than those for dissolving a business and then creating a new company, but just ignoring an old business out of good standing would still leave business owners personally liable to debts and other liability related to or emanating out of the old business, potentially even from other owners or shareholders of that business who have been left in the wind.

Additionally, mismanagement of the company in a number of ways can also allow a plaintiff to “pierce the corporate veil” of liability protection, and gain access to a business owner’s personal assets and funds to recover damages.  When the veil of limited liability is pierced, the business’s creditors can reach the owner’s personal assets outside of those of the business.  In short, limited liability protection, perhaps the most important attribute of an LLC or a corporation, is lost.

The courts may allow a plaintiff/creditor to pierce the corporate veil if they can prove one of the following three legal theories:

  • Undercapitalization. The creditor must prove that the owner intentionally underfunded the entity, when it was formed, to defraud the business’s creditors.  This is more common where there is a holding company with many subsidiaries and the holding company underfunds subsidiaries with high liability or where a company attempts to minimize assets in a branch of a company that has high liability.
  • Alter Ego. The creditor must establish that the business owner failed to separate his financial affairs from the entity’s financial affairs, and/or observe statutory formalities regarding division of authority within the entity, required meetings, and recordkeeping.  This is a more common theory of recovery.
  • Lack of Insurance.  Another theory under which courts have allowed the corporate veil to be pierced is where a company failed to secure any or adequate insurance for a certain business, branch or activity.  If the insurance is inadequate under contract, statute, or respective to the activities or liabilities in which the business engages.

If a business isn’t in good standing or a plaintiff/creditor pierces the corporate veil the owners automatically may have unlimited, personal liability for all of the business’s debts and liabilities.  This is why it’s vital to keep the company in good standing with the Secretary of State and properly maintain all other business records, capitalization, and insurance.

Forrest P. Merithew, Attorney at Law has regularly represented and defended a wide range of business in civil, commercial and complex litigation.  Through his active litigation representation and defense he has encountered and addressed a number of these issues.  He applies this background to his business representation and development practice, in conjunction with contracts, liability analysis, and proactive risk management.  He has seen the amount and diversity of outdoor recreation businesses and outfitters has expanded quickly over the last 5 years and fears that many such businesses are not aware of the requirements and maintenance for business entity structures in order to secure limited liability protection in activities of high liability and risk.

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