Personal Liability Pitfalls in Maintaining Corporate Filings, Books and Records

It is widely recognized among large and small business owners alike that running a business through an incorporated business entity can provide officers and directors invaluable protection against personal liability for acts of the business.  Whether formed as a corporation or other form of limited liability entity, such as a limited liability company (“LLC”), limited partnership (“LP”), or limited liability partnership (“LP”), utilizing an entity structure can shield personal assets from those collecting judgments or other debts against the business.  

While careful entity planning is the first step in personal liability protection, it is not the only step.  In order to enjoy the liability limitations afforded by business entity structures, it is critical to maintain the entity in good standing by filing with various offices of the State of Texas all required statutory reports, including in particular those arising under Chapter 171 of the Texas Tax Code.  It is equally important to maintain corporate formalities and keep corporate books and records up to date. 

State Filings

Business entities in Texas are subject to a number of requirements for annual and periodic filings with the Texas Comptroller and Texas Secretary of State.  These include, among others, annual Texas franchise tax reports, annual information reports, and other periodic information reports to update corporate information, such as registered agent, registered office, and various shareholder or partnership interests.  

The specific reports required for each entity vary based upon entity type and ownership, as well as revenues and margins.  Business entities in Texas also may be subject to payment of franchise taxes, or may be required to allow the Texas Comptroller to examine the company’s books and records to verify tax obligations. 

Failing to timely file required reports, to pay taxes due, or to allow inspection by the Comptroller can have significant consequences.  For example, such failures may lead to the forfeiture of an entity’s corporate privileges, including but not limited to the right to transact business in Texas and the right to sue or defend virtually all lawsuits in Texas.  Similarly, under certain circumstances an LLP can be converted to a general partnership for failing to file its annual certificate.  When corporate privileges are forfeited or an LLP becomes a general partnership by operation of statute, the directors, officers, or partners may become personally liable for all debts created or incurred in Texas after the date of forfeiture. 

While an entity with forfeited or converted status may later be reinstated, the reinstatement generally does not absolve the directors, officers, or partners of any personal liability accruing by statutory operation.  In other words, even if the entity’s status is later reinstated, the owners’ and operators’ personal assets may remain exposed to substantial claims based on contracts made, debts incurred, or torts committed during the forfeiture period.  

Corporate Books and Records

            In addition to filings with the State, it is crucial that Texas business entities keep their books and records updated to maintain personal liability limitations.  Whether a corporation, LLC, LP, LLP, or other type, a limited liability business entity is considered a “legal fiction”—an entity which exists by operation of law as separate and distinct from its owners and operators.  Generally this legal fiction protects the owners and operators from personal liability for acts of the business entity.  

Under certain circumstances, however, the entity may be disregarded—known as “piercing the corporate veil.”  When the veil is pierced, the owners or operators become personally liable for the acts and obligations of the business, just as when an entity’s right to do business is forfeited as discussed above.  Failing to maintain the entity’s books and records can support a claim for veil piercing. 

For example, a business entity may be disregarded where it becomes a mere “alter ego” for the owners or operators.  This occurs when the personal assets or affairs of the owners or operators become so comingled with those of the business that the two become indistinguishable.  While failing to maintain the business books and records may not alone be enough to pierce the veil, it can be evidence supporting an alter ego finding.  If the entity has not held regular meetings (e.g., shareholder, director, or member meetings), elected entity officials (e.g., directors, officers, or managers), issued shares, or maintained ownership allocation tables, among other things, the veil may be pierced and the owners or operators of the business may be held personally liable for what would otherwise have been corporate acts or obligations. 

Similarly, the veil may be pierced where two or more businesses are operated as a single business enterprise.  Under this theory, one entity may be held liable for the acts or obligations of another related entity where the operations of the two are so comingled that they become indistinguishable.  As with alter ego, failure to maintain each entity’s books and records can support piercing the veil.  Under certain circumstances, a single business enterprise analysis could be combined with an alter ego analysis to pierce through both corporate entities and hold the owners or operators personally liable. 

Accordingly, even the best laid business entity plans can go awry when corporate filings and corporate books and records are not properly maintained.  In both contexts, personal liability can be created where it otherwise would not have existed.  While this can, of course, pose a significant risk for business owners and operators defending a lawsuit, it can also provide substantial leverage in prosecuting a lawsuit against an entity and its individual owners and operators relating to actions during a time of forfeited corporate privileges. 

By: Michael R. Steinmark.

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