Article May 1, 2014

Risks of Not Properly Dissolving Your Limited Liability Company

If your limited liability company was properly formed and operated, you should generally be protected from personal liability for its debts.

ARS 29-651: Liability to third parties Except as provided in this chapter, a member, manager, employee, officer or agent of a limited liability company is not liable, solely by reason of being a member, manager, employee, officer or agent, for the debts, obligations and liabilities of the limited liability company whether arising in contract or tort, under a judgment, decree or order of a court or otherwise.

If the LLC cannot pay its creditors, including landlords, then your creditors cannot come after your personal possessions or other members of your LLC. Because creditors can collect only from the assets of the company, creditors cannot collect from your personal assets, and your wages can’t be garnished. But as with most rules of law, there are exceptions. One such exception occurs when a member who is responsible for winding up the affairs of the limited liability company does so improperly.

Hypothetical: A client arrives for a consultation and shares the following:

My business partners and I owned a limited liability company (LLC). Financially things were good until a few years ago. Things got really tight. At some point we each began to pursue other business opportunities. We basically just quit working at the company. Eventually our corporate statutory agent withdrew and our company was administratively dissolved by the Arizona Corporation Commission. We never filed for dissolution with the state. We had two years left on a five-year lease agreement. About this time one of my business partners filed bankruptcy. My other partner kept all of the assets of the business, including a couple of automobiles, business furniture, and some nice computers. Although the business is now closed, the landlord sent us collections notices. When we didn’t respond he filed a lawsuit against each of us personally. We can’t pay. Now our former commercial landlord is trying to garnish my wages. Am I personally liable for these debts although our business is dissolved? We cannot afford litigation.

To our knowledge, Arizona currently has no case directly on point to this question. However, general statutes and cases decided in other states offer some valuable insights. Let’s start with Arizona statutes.

In Arizona a LLC can be dissolved in several ways. One way is for the Arizona Corporation Commission to administratively dissolve the limited liability company. This might occur when a statutory agent resigns and the company fails to name a new statutory agent. Once the corporation gives notice that administrative dissolution is pending, the company has the opportunity to correct the grounds for dissolution, and, if it fails to do so, the company is dissolved. Then, if the company does not apply for reinstatement the LLC is no longer a separate legal entity. In Arizona, a limited liability company that is administratively dissolved “continues in existence but may not carry on any business except as necessary to wind up and liquidate its business and affairs under 29-782, subsection B.” A.R.S. § 29-786. The process of winding up a company’s affairs includes paying its creditors from company assets. Generally members are not personally liable for any unresolved claims if they’ve complied with the winding up procedures.

But what happens when the members fail or refuse to follow the winding up procedures required by Arizona statutes, particularly when the company owns substantial assets. We have successfully argued to both the Superior Court, and to the bankruptcy court, that in such a case the members of the LLC are deemed to have diverted assets that should have been applied for the benefit of creditors. It is a form of defrauding creditors, and the existing members of the company may incur personal liability for the outstanding liabilities of their company. By failing to properly wind-up the LLC, including filing the required Articles of Termination, the LLC liabilities become the liabilities of each of the members of the LLC. We have successfully argued that such liability attaches to each member individually at the time the limited liability company is administratively dissolved by the Arizona Corporation Commission. This is because instead of applying company assets for the benefit of the creditors the members of the LLC essentially divert those assets as their own personal property. It is important to emphasize that a creditor’s claims against the LLC members arise from the fraudulent transfer of company assets which renders the company insolvent. The claims do not arise from the breach of contract by their limited liability company.

Other Ways to Incur Personal Liability

Personal Guaranty. Of course the biggest exception to ARS §29-651 is that you may have signed a personal guaranty. For example, your landlord may be allowed to pursue you personally (instead or in addition to the LLC) if you signed a personal guaranty. You need to carefully review the lease agreement to determine whether the now closed LLC is liable for the unpaid rent or whether you are personally liable. The bad news is that if you signed a personal guarantee, you may have little legal recourse. A personal guarantee means that you are individually on the hook for your company’s debt. (Note: business owners who are asked to sign personal guarantees for leases can limit their exposure by offering their landlords larger security deposits or letters of credit in lieu of a personal guaranty. Other landlords will allow you to cap a guaranty at a certain amount, say six months of rent. Still others will allow the guaranty to expire if there has not been any default after a year or so.)

Failing To Preserve the Integrity of the Limited Liability Company. It is also possible that you took some action while your company was in business that removed the protection of your LLC, such as mingling personal and company funds. The LLC’s activities, and especially its finances, must be operated completely separate from those of the members of the LLC. The most important factor in ensuring liability protection is to treat the LLC as a separate entity. If a court feels that the owners have been treating the LLC as an extension of their personal affairs, then the court will often find that the LLC never really existed and that the owners were doing business as individuals. In that case, the court may find that, despite the fact that a LLC was in place, the individual owners may be personally liable for the LLC’s debts.

Fraud. You may also be held liable for company debts if you intentionally commit fraud or fail to deposit taxes withheld from employee wages.

Conclusion

Sit down and look over your LLC operating agreement, which is the organizational document for your former company, and make sure you have followed proper procedures for forming, operating, and dissolving the company. If you have, that will help make your case that you should not be personally liable for the debts of your former company. In general, having a LLC operating agreement, maintaining a separate business bank accounts, obtaining a federal employer identification number, and properly funding the LLC can all help to protect individual owners from liability. It is also always smart to have business insurance in place to protect business owners. If you do run into financial trouble, make sure you go through the steps to formally dissolve your limited liability company.