Foreigners starting a business in the U.S. (and often also American business owners) wonder whether they can be called to answer for their company’s debts and liabilities. It is useful to understand that this can happen and it is even more useful to understand how to avoid it.
The general rule is that shareholders and LLC members are not personally responsible for debts and liabilities of a corporation or LLC: they can be held responsible only for the value of their investment in the entity. This is called limited liability protection and it is a matter of state law. For example, shareholders/members cannot be asked to pay for corporate income taxes, to reimburse a creditor of the entity, or to pay a judgment entered against the entity.
However, this rule – as every rule I can think of – is subject to exceptions. In certain cases shareholders and members can incur personal liability and creditors may attack their personal assets. This happens at least in the following cases:
- “Piercing the veil” of the LLC/corporation. Courts allow the piercing of the veil in numerous circumstances.[i] Some examples are: i) when the entity commits fraud and wrongdoing; ii) when the entity did not follow corporate formalities; iii) when shareholders have failed to maintain separation between the entity and its owners (i.e., its shareholders do not respect it as a separate entity and act as alter ego of the corporation); iv) when the entity is not adequately capitalized; v) when, if the veil is not pierced, creditors or other third parties suffer injustice. See more here.
- Personal guaranties. This happens when the shareholders/members undertake to personally guarantee the corporation’s obligations to the extent specified in a guarantee. It is common for small business owners to sign limited or unlimited personal guarantees for their business to borrow money. Should there be outstanding payments, the guarantor would be required to pay back either the whole defaulted amount (plus legal fees to recover the sum) or the amount for which he/she is liable. If more than one shareholder undertakes the personal guarantee, then each of the guarantors (depending on the loan agreement) may be held jointly and severally liable in case of default by the lender. See more here. Also taking out personal loans or home equity loans to fund the business may make shareholders personally liable. In addition, shareholders should remember that they are almost always personally responsible for making payments on credit cards, even if they have the corporation’s name on them, according to the terms they signed.
- Tortious act or omission by shareholders or members. Another frequent case of personal liability is when a shareholder/member commits a tortious act or omission (negligence, fraud or illegal act: see here for definition of tort and here for definition of omission). Shareholders/members may commit torts for the entity’s benefit or for themselves. For example, a negligent omission when the shareholder/member had a duty to act, may cause personal liability. Also, shareholders/members who knowingly receive illegal distributions will be liable for the full amount of those distributions. It’s a long-established principle. See John A. Roebling’s Sons Co. v. Mode, 17 Del. 515 (Del. Superior Court 1899).
- Liability for consenting to distribution in violation of law. As a general rule the board of directors may authorize distributions to shareholders, but restrictions exist (by law or contract). Generally, state laws limit a corporation’s ability to make distributions to shareholders to guarantee that the entity satisfies its debts first. Shareholders receive illegal distributions when they receive payments (of property, cash, etc.) in violation of written agreements or the company’s bylaws. An example of distribution in violation of the law is when, pending a lawsuit, the shareholders quickly liquidate the company and distribute the assets violating preemptive creditors’ rights. More on dividends is available here.
- Failure to remit employee withholding taxes. Employers must deposit and report employment taxes. Employers generally must withhold federal income tax from employees’ wages. The penalties for failing to pay these taxes can be assessed, not only against their company, but also against those making the decision not to pay them. In case of failure to pay these taxes, the IRS holds personally liable all persons who could have prevented the non-payment.[ii]
- Failure to pay sales taxes. States generally impose sales taxes on certain taxable transfers of goods or services. Tax rates vary widely by jurisdiction and range from less than 1% to over 10%. See here. All states imposing sales taxes require that taxes collected be paid to the state at least quarterly. Once collected, sales taxes are considered held in trust and if they are not duly turned over to the state, there might be potential criminal liability for theft of state funds. In addition, state tax laws may impose personal liability. E.g., Fla. Stat. §213.29; Ind. Code §6-2.5-9-3(2); Va. Code Ann. §58.1-1815. “Any person” responsible for tax payment may be held liable under state tax law, based on some degree of culpability. However, there are other states that impose derivative or “strict” liability on individuals based solely on their ownership interest in or position with the company, regardless of their individual blameworthiness. See here.
The above situations are not the only possible exceptions to the limited liability rule for shareholders/members and state laws vary on the topic. For more information concerning the personal liability of shareholders, members (and directors) in New York, Delaware, Wyoming, and Nevada see which American state is the best to form a legal entity? an overview for foreigners – part three.
[i] Scholars have identified three reasons of why courts allow the piercing of the veil. See more here: https://corpgov.law.harvard.edu/2014/03/27/the-three-justifications-for-piercing-the-corporate-veil/
[ii] The penalty for failing to pay employment taxes is based on the number of days the deposit is late. See here. In addition to IRS penalties, not paying payroll taxes could even result in criminal penalties and imprisonment. If found guilty of willful failure to comply with federal employment tax laws, one can be fined up to $10,000 and/or be imprisoned for up to five years. See here. For more on employees taxes see here.