When selecting an entity, one must consider what happens if the business cannot pay its creditors or satisfy judgments against it. This may matter for some businesses more than for others. Also, note that in most states, businesses must have business liability insurance to cover property damage claims. In the event the insurance coverage is not enough to cover a debt or business assets are depleted and there is still a debt, the business owners may have to satisfy that debt with their own personal assets.
General partners are personally liable for partnership debts. How does this work? Say you have four equal partners, that all have assets which can be used to pay for the debt. Then each will have to pay 25% of the debt. But, if one of the partners has no assets, then the other three will have to pay the debt 1/3 each. If 3 of the 4 cannot pay, then the one partner who has the means to pay will have to pay it all. 💡 What do you think the policy or rationale is behind holding one partner liable for the entirety if the others cannot pay?
Limited partners have no personal liability exposure unless they are involved so much in the management of the business that they essentially convert to general partner status. What a limited partner loses is simply their investment in the partnership. 💡 Think about how you can advise limited partners to protect them.
While you may feel as though the above is pretty scary, the good news is that shareholders and LLC members are insulated from personal liability exposure. (Remember when I said that LLCs are like corporations in some ways, this is the most important way!)
Personal liability insulation is not absolute however and there are instances where a shareholder or member can be personally liable. This concept is called “piercing the veil.” While details on piercing are beyond the scope of this course, it is important to know about it so that you can ensure the owners have measures in place to protect them. To pierce simply means that a creditor can bypass the entity (corporation or LLC) and demand payment from its owners. Generally, courts are reluctant to pierce the limited liability veil but in some instances it’s warranted. Factors the courts consider are:
- Whether a company is grossly undercapitalized at formation
- Whether the owners used the company’s assets as their own
- Whether the owners commingled or siphoned business funds for their personal use
- Whether the owners failed to observe formalities (this is more of a corporate concept but can impact LLCs somewhat)
- Whether there is an injustice in operations (this goes along with siphoning sometimes)
- And in some states, fraud or fraudulent intent must be proven
💡 Knowing the above, think about how you can advise shareholders and LLC owners to protect them from potential piercing if the business can no longer pay its debts.