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Choice of Business Entity (Part 2)
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 msaunders@lgattorneys.com.
Administrative Dissolution May Breach a Company's Third-Party Contracts
Under Illinois law, corporations and limited liability companies (“LLCs”) are required to file annual registrations with the Illinois Secretary of State in order to maintain their entities in good standing. Pursuant to the Limited Liability Company Act (the “LLC Act”), the Secretary of State may administratively dissolve an LLC if it fails to timely file its annual registration, mirroring the requirement imposed upon corporations in the Business Corporation Act (the “Corporation Act”).
If a company is administratively dissolved, the company will be reinstated upon the filing of the outstanding annual report(s) and an application for reinstatement, along with payment of all outstanding taxes and fees. Upon reinstatement, the actions made by the company during the period of administrative dissolution are “ratified and confirmed” pursuant to the “relation-back” provisions of the LLC Act or the Corporation Act.
Recently, a provision of the LLC Act was examined by the Illinois Appellate Court in CF SBC Pledgor 1 2012-1 Trust v. Clark/School LLC, 2016 IL App (4th) 150568 (Sep. 8, 2016). In this case, the Plaintiff, a Delaware mortgage trust, assumed a mortgage and security interest in an eight-building apartment complex which was owned by the defendant, Clark/School LLC. Under the security agreement, the loan was made on the lender’s reliance of the Defendant mortgagor’s “continued existence” as an LLC, including “all things necessary to preserve and maintain [its] existence and to ensure its continuous right to carry on its business.” The Defendant unfortunately failed to timely file its annual registration with the Illinois Secretary of State, ultimately leading to its administrative dissolution in December 2013.
Due to the Defendant’s administrative dissolution, the Plaintiff initiated a mortgage foreclosure action against the Defendant for failing to “preserve and maintain its existence” as an LLC. The lower court determined, and the Illinois Appellate Court subsequently affirmed, that the Defendant committed an event of default by failing to maintain its status in good standing and held for the Plaintiff. The Defendant unsuccessfully argued that the relation-back provision of the LLC Act prevented the Defendant from liability under the security agreement because it validated any actions that were taken from the date of the Defendant’s dissolution through the date of its reinstatement by the Secretary of State.
The predicament in CF SBC Pledgor was a novel issue under established Illinois LLC law; thus, the Illinois Appellate Court looked to precedent under the Corporation Act. The relation-back application of the Corporation Act only pertained to ratification of the corporation’s actions; however, it did not automatically protect the corporation from possible breaches under third-party contracts. Looking to the Corporation Act, the Court found that the relation-back provision will not “impose a legal fiction that belies actual real world facts.”
In that regard, a company cannot use the relation-back provision of its respective governing law in order to escape liability for committing a breach in a contractual agreement whereby the contracting party is relying upon the company to maintain its “continued existence” as a legal entity in good standing with the Secretary of State.
A company should pay prudent attention to its required filings and its obligations under its third-party contracts so as not to inadvertently breach such contracts. Otherwise, as was the case in CF SBC Pledgor the consequences may be harsh.
For more information on this topic or how you can protect your corporation or limited liability company, please contact:
Pamela Szelung at:
pszelung@lgattorneys.com or 312-368-0100.