As the owner of a corporation, when you set up your business, you and your lawyer believed that you had taken all necessary steps to protect your personal assets. After all, the primary reason you set up a corporation was to shield your own assets from your business’s creditors. In order to ensure that your assets are safe from the corporation’s creditors, you need to do more than just fill out the Secretary of State’s paperwork. The corporation must conduct itself as an entity separate and apart from you as the owner.
A recent decision provides a “textbook” example of how an owner of a corporation can put his own assets at risk simply by the way he conducted his company’s business. In Puntillo v. Dave Knecht Homes, the plaintiffs were a married couple who entered into a contract with a home builder, a corporation. The defendants, David and Karen Knecht, were the beneficiaries of a trust that held the home builder’s shares of stock. They were, in essence, the owners of the home-builder corporation. After the home was completed, it was riddled with defects and the couple obtained a judgment against the corporation. Thereafter, the corporation dissolved and the couple was unable to enforce their judgment. In the midst of all of it, a new corporation, Dave Knecht Homes, was created with similar ownership, management, staff, purpose and resources as the now asset-less builder. The defunct builder and the new company used the same line of credit. Beginning in 2006, Dave Knecht’s personal line of credit began funding the now defunct builder’s operations. After the new corporation, Dave Knecht Homes, came along, it also used the same credit line. After being unable to collect on its judgment against the out-of-business builder, the plaintiffs sued Dave Knecht Homes and its owners Dave and Karen Hecht personally. The plaintiffs claimed the new company was merely a successor to the defunct corporation and the corporate veil between the individuals and the successor, Dave Knecht Homes, should be “pierced,” allowing the plaintiffs to go after the individual owners for a corporation’s debt.
Generally, a corporation that purchases the assets of another corporation is not liable for the debts or liabilities of the selling corporation. There are, however, four exceptions to this general rule of successor corporate nonliability: (1) where an express or implied agreement of assumption of the liability exists; (2) where the transaction amounts to a consolidation or merger of the purchaser or seller corporation; (3) where the purchaser is merely a continuation of the seller; or (4) where the transaction is for the fraudulent purpose of escaping liability for the seller’s obligations. In this case, the plaintiffs successfully argued that Dave Knecht Homes is a “mere continuation” of the former company and the court agreed. The continuation exception applies when the purchasing corporation is “merely a continuation or reincarnation of the selling corporation.” In other words, the purchasing corporation maintains the same or similar management and ownership, but merely wears different clothes. The Illinois Supreme Court has made it clear that “[t]he exception is designed to prevent a situation whereby the specific purpose of acquiring assets is to place those assets out of the reach of the predecessor’s creditors.” To determine whether one corporate entity is a continuation of another, courts consider “whether there is a continuation of the corporate entity of the seller—not whether there is a continuation of the seller’s business operation.” Thus, the plaintiffs were permitted to look to the assets of the new company to satisfy their judgment. Unfortunately for the Knechts, it didn’t end there.
The plaintiffs also argued that the out-of-business corporation served as the Knecht’s “alter ego” and that the court should pierce the defunct builder’s corporate veil and impose individual liability against the Knechts. A court may disregard a corporate entity and pierce the veil of limited liability where the corporation is merely the alter ego or business conduit of another person or entity.” This doctrine imposes liability on the individual or entity that “uses a corporation merely as an instrumentality to conduct that person’s or entity’s business.” In Illinois, courts use a two-prong test to determine whether to pierce the corporate veil: “(1) there must be such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist; and (2) circumstances must exist such that adherence to the fiction of a separate corporate existence would sanction a fraud, promote injustice, or promote inequitable consequences.
The court found that the Knechts exercised control over the new builder and treated the company’s assets as their own, causing the company to pay significant sums of money for their own personal expenses including federal and state income tax payments, landscaping for their personal residences; personal life insurance premiums and attorney’s fees. Moreover, the Knechts caused the failed company to pay their personal expenses using David Knecht’s credit line. By causing Knecht’s former company to pay their significant personal expenses, the Knechts treated the company’s assets as their own. The court pierced the corporate veil of Dave Knecht Homes (who it imposed successor liability upon) and allowed the plaintiffs to enforce their judgment against David Hecht Homes and the individual defendants.
In order to insulate yourself from personal liability, as a business owner, the way that you run the business is as important as setting up the corporation in the first place.
For more information, please contact:
Howard Teplinsky at: email@example.com or 312-368-0100.
In Part 1, we explored doing business as a sole proprietor or in a partnership. A problem with those types of business entities was that they did not shield the sole proprietor or the general partner from the claims of creditors of the business. This installment will briefly discuss the operation of a business through a corporation or a limited liability company, two forms which, if established and operated correctly, can provide the owners with limited liability.
In a corporation, the owners (“shareholders”) generally have limited liability for the corporation’s conduct of the business. This liability is “limited” to the shareholder’s investment in the corporation. This is applicable, even if there is only one shareholder. While generally the liability is limited, the corporation must observe all the corporate formalities, such as having regular meetings of its directors and shareholders, documenting all action taken (leasing property, setting up a bank account, paying compensation and dividends to the shareholders), and owning or leasing its own property, and treat the business as a separate entity. If they fail to do so, creditors may be able to “pierce the corporate veil” and assert the liability of the corporation against the shareholders.
In a limited liability company (”LLC”) as in a corporation, the owners (“members”) generally have limited liability for the LLC’s conduct of the business. Unlike a corporation, an LLC does not have to observe formalities, such as conducting meetings and documenting the actions of the LLC. However, the members must treat the LLC as a separate entity with its own assets, including bank accounts, and liabilities.
Note that other issues may arise when selecting your choice of entity. A corporation may be either a “C-corporation” or an “S-corporation.” An LLC can be ignored for income tax purposes if there is only one member; if there is more than one member, it may be treated as a partnership. If the member(s) otherwise elect, an LLC could be treated as a corporation (C-corporation, or S-corporation). No matter what the income tax election or consequences, the income tax treatment has no effect on liability issues.
This article and Part 1 have each addressed, in general terms, the types of business entities available to the business owner. No decision should be made without considering all of the issues. Please feel free to contact us with any questions you have regarding this or any other legal issues confronting your business.
If you are starting a business or have any questions regarding the legal alternatives available to your business, please contact:
312-368-0100 or firstname.lastname@example.org.