When Colorado business owners choose the form of their business, they have several options. The most popular are probably the corporation, with directors and shareholders, or the limited liability company, with members and managers. The choice between the two often boils down to various accounting and tax considerations more than anything else, making a business Certified Public Accountant just as important as an attorney when making the decision.
One additional consideration that does not get talked about as much is the additional protection that limited liability companies provide against creditor claims against individual owners. One of the key reasons to do business as a limited liability company or corporation in Colorado is to take advantage of limited liability. The entity is a legal person distinct from its owners that can do business, sign contracts, borrow money, and even find itself in legal jeopardy independent of its owners. Limited Liability means that, theoretically, the individual owners are not responsible for the debts or obligations of the owner. Both corporations and limited liability companies offer this protection.
Similarly, both kinds of entities are subject to breaking this protection in specific circumstances. Creditors or tort victims can try to “pierce the corporate veil” and find owners liability, but that requires the creditor prove that adherence to the corporate fiction would promote injustice, protect fraud, defeat a legitimate claim, or defend crime, the invocation of equitable principles for the imposition of personal liability may occur. While it is not technically required that the owner or company was engaged in some kind of tortious action, it may be difficult to prove alter ego liability without at least some kind of tort involved.
What is The Difference Between Limited Liability and Owner Liability
The difference between owner liability for corporations versus limited liability companies arise when the business fails without particular fraud or fault and its assets are disbursed. This happened to many businesses that failed during Covid-19 or the related government shutdowns. It could result from a loss of customer base or a messy business divorce. The list of reasons a business may legitimately fail is probably as diverse as the number of businesses.
Sometimes, a creditor has contractual rights that go beyond claims against the corporation. If the debt relates to a note or other contractual obligation then there may be built-in remedies. For example, if the loan is secured, the creditor may be able to foreclose on the security to satisfy the debt. If there is a personal guarantee, then the creditor may have a cause of action against the owners that individual guaranteed the debt. If there are co-debtors, perhaps there is a remedy here as well.
But, absent piercing the veil or a contractual right, can creditors do anything to go after owners if the business distributes assets when it shuts down? That depends on whether the company was formed as a corporation or a limited liability company. For corporations, the Colorado Supreme Court held in the Ficor case that directors who vote for a distribution while the company is insolvent may be liable to its creditors. Even though no individual creditor has the right to sue a shareholder for taking a distribution while the company was insolvent, the creditors can bring an action on behalf of all creditors. The idea is that any recovery is then divided up among the creditors of the corporation as they may determine or a court might later decide.
In the case of limited liability companies, though, the situation is very different. In Weinstein, the Colorado Supreme Court held that Ficor does not apply to limited liability companies and that creditors may not assert a claim against individual members for unlawful distribution. Similarly, the Court held that managers of a limited liability company do not have fiduciary duties to creditors. There may be other, less direct options for a creditor to seek relief in the name of the company itself, but this would require far more work by the creditor such as filing an involuntary bankruptcy and may be too expensive in most circumstances.
So, while the form of entity is probably going to be mostly an accounting decision, owners looking to invest in a new venture should never neglect seeking legal advice. If your company has a high risk of going out of business but still having assets to return to the investors, you may want to consider a limited liability company over a corporation. Want to know more? Contact one of our Denver Business Attorneys for help!