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Small business owners should be cautious about personal liability amid the COVID-19 crisis

March 30, 2020 | By Patrick T. McCloskey

COVID-19 has turned the business world upside down in New York City. Executive Orders signed by Governor Andrew Cuomo and Mayor Bill de Blasio have, among other things, required the entire non-essential workforce to telecommute and required the outright closure of other specified non-essential businesses, in each case as a temporary measure to address the public health crisis.

To use Governor Cuomo’s phrase, with the valve essentially shut, revenue for many New York City businesses has come to a screeching halt, creating a dire need for working capital. As small business owners scramble to bridge this gap, they should be cautious about turning business risks into personal risks. With the crisis unfolding at a rapid pace and the already blurry line between work and personal life almost disappearing as working remotely becomes the new normal, the circumstances are ripe for small business owners to overlook this potential pitfall.

At the outset, this article assumes that small business owners (“SBOs”) operate their enterprise through a corporation or limited liability company (“LLC”), each of which provides the protection of the so-called “corporate veil” (more on this below).1 As a general rule, the owners of these entities do not have personal liability for the obligations of the entity.

Unfortunately, as the expression goes, every rule has its exceptions. While this article does not provide exhaustive coverage of every instance where a shareholder of a corporation or a member of a limited liability company could be held personally liable, the goal is to identify the ones that are most likely to surface as small businesses in New York City fight their way through the COVID-19 crisis.

Personal Guaranties

Personal guaranties are an obvious way for an SBO to put his or her personal assets at risk. Banks and other lenders will often require a personal guaranty from one or more of the principal equity owners when the entity’s collateral will leave the lender undersecured or the loan itself is particularly risky. Unfortunately, given the economic carnage caused by COVID-19, many New York small businesses may fit this profile.

It is worth noting that, under the recently enacted CARES Act, SBA-guaranteed loans made under the Paycheck Protection Program and Economic Injury Disaster Loans of $200,000 or less will not require a personal guaranty. This is obviously good news for small businesses that receive such loans, but the personal guaranty may surface for other loans or credit extended during the COVID-19 crisis.

While most SBOs likely understand that a personal guaranty will put their personal assets at risk, they may not fully appreciate that banks typically insist that guaranties contain waivers up the wazoo. For starters, most guaranties are so-called “guaranties of payment, not collection,” meaning the lender is not obligated to seek payment or exhaust default remedies against the borrowing entity in the first instance. Instead, the lender preserves the ability to leapfrog the borrowing entity and go right after the guarantor for direct payment upon a default. In addition, most guaranties are “continuing guarantees,” meaning the lender doesn’t need the consent of the guarantor if the underlying debt is increased or the collateral securing the underlying debt is decreased or otherwise modified. While a so-called continuing guarantee may not be an issue for a guarantor who controls management of the entity (since such guarantor would presumably be able to control the amount of money borrowed/collateral pledged), a non-management guarantor will be on the hook for risks beyond his or her control. Guarantors are also typically required to waive any defense the borrowing entity has or may have against the lender. As an example, if there were an enforceability issue with the underlying loan or credit agreement, that defense would not be available to the guarantor, who would nevertheless remain obligated for payment.

While SBOs will obviously want to resist a personal guaranty, they may be faced with a Hobson’s choice if a lender offering a working capital lifeline insists on one. To the extent a personal guaranty is required, an SBO should at least try for a limited guaranty that cannot exceed a specified dollar amount the SBO is comfortable with. The SBO should also negotiate for a non-recourse guaranty, where the risk on enforcement would be limited to certain specific collateral pledged by the guarantor, with the remaining personal assets of the SBO off limits.

Corporate Formalities

In New York, as in most other jurisdictions, the so-called corporate veil will only be pierced to impose personal liability on corporate shareholders and LLC members in limited circumstances. To preserve the protection of this shield amid the COVID-19 chaos, SBOs should understand that disregarding corporate formalities can move the needle in the direction of veil piercing.

While strict adherence to corporate formalities may be a challenge in the remote mandate environment of the COVID-19 outbreak, SBOs should, at the very least, avoid commingling business and personal assets. Even if it is easier and faster for an SBO to pay business creditors from a personal bank account or with a personal credit card, these shortcuts should be avoided. Although it is an extra step, the preferable course of action would be for the SBO to first transfer the funds from the personal account into the business account, and then have the entity make the payment. The initial transfer should be appropriately documented to reflect a loan or an equity contribution and the transaction with the creditor should be documented to make it crystal clear the entity, not the SBO, is the transaction party. Most of the time this can be accomplished by the SBO simply executing all documents on behalf of the entity in his or her capacity as an authorized officer or agent with the appropriate title.

While a “one-off” in a time crunch is unlikely, by itself, to cause the corporate veil to be pierced in New York, making payments on behalf of the business from a personal bank account or with a personal credit card with any frequency will give a creditor ammunition to claim the entity was the “alter ego” of the SBO, which will enhance the argument for personal liability. This is especially the case if the SBO is the sole equity owner of the entity. Even though New York courts typically require some type of wrongdoing in addition to dominion and control to pierce the corporate veil, the better course of action is to avoid giving an aggrieved creditor anything to latch onto.

Employee Wages

Most SBOs likely realize there could be personal liability for unpaid payroll taxes, but they may not be aware that, under New York law, the ten largest equity owners of corporations (whose shares are privately held) and LLCs can have personal liability for all “debts, wages or salaries” owed to employees for services performed in New York. While the liability is not automatic (the employee needs to provide advance notice to the equity holder(s) and provide an opportunity to pay before suing), the risk is there and personal liability can attach if an employee follows the required procedures.

Until recently this potential liability only applied to New York corporations, but the laws have been amended so they now apply to both domestic and foreign corporations (whose shares are not publicly traded) and LLCs.

Without suggesting any SBO would intentionally stiff an employee in this environment, any small business that is teetering needs to keep this issue on the radar once working capital becomes scarce. One quirky aspect of these New York statutes is that a top ten equity holder has exposure even if it has no management control and is not involved in decisions about where to deploy dwindling cash resources.

Sales Taxes

Even though businesses affected by COVID-19 can apply for a waiver of penalties and interest for New York State sales tax filings and payments made after the March 20, 2020 deadline, (i) the cash comprising these collected sales taxes are technically state property and are meant to be held in trust on the state’s behalf and (ii) even with the waiver, such funds still need to be paid within 60 days of the deadline.

Under New York law, an SBO who is also an officer, director or employee of a corporation can be held personally liable for unpaid sales taxes if he or she is “under a duty to act” or “has so acted” in the collection of sales and use taxes on behalf of the corporation. The personal exposure for unpaid sales taxes is much broader for an SBO of an LLC because it extends beyond managing members and includes even non-manager, minority members.

The bottom line on this issue is that SBOs should understand they could have personal liability for unpaid sales and use taxes owed to New York State. Postponements arising from any waiver of penalties and interest for filing and paying past the deadline might cause this to fall off the radar, which can obviously have unwelcomed consequences, especially if the business ultimately fails.

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1 A sole proprietor, by legal definition, has personal liability for the obligations of its business, as do the partners of a general partnership. With respect to a limited partnership, the general partner(s) have personal liability for the obligations of the business, but the limited partners do not.

This blog post is for general informational purposes only and does not constitute legal advice. No one should rely on the information in this blog post without seeking appropriate legal, accounting, tax or other appropriate advice from an attorney, accountant or other professional properly licensed in the applicable jurisdiction(s).