Friday, November 3, 2006
What Do You Do If Your Business is in Financial Trouble?
This week our topic is financially troubled businesses, and we’ll be speaking with attorney Fred Steingold, author of the best-selling title, “A Legal Guide for Starting and Running a Small Business.”
NOLO: Fred, your book, A Legal Guide for Starting and Running a Small Business, covers a lot of material. It’s easy to see why it’s one of the best-selling guides on the subject. But in this broadcast, we’re particularly interested in your chapter about the financially troubled business. One of the things you mentioned in that chapter is that a businessperson needs to think ahead to protect personal assets. How does a person develop an asset protection plan?
FRED STEINGOLD: Let’s say you own a home, car, you’ve got stocks and bonds, you’ve got a savings account… those are your personal assets. You’ve worked hard probably to acquire those things, and you want to protect those assets to the greatest extent possible in case your business fails. You don’t want to have some creditor seize those assets to pay for business debts, so your asset protection plan is all about protecting those assets, and it starts with your choice of entity. By that, I mean how you’re going to do business, and how your business is going to be structured. There are two basic ways. One is either having a sole proprietorship or a partnership, and in either of those cases, you’ve got complete exposure. If you’re a sole proprietor for example, all of your assets are at risk for whatever the business does. If you have a partnership, each partner is personally reliable for all the business debts, and so, you’re completely at risk. Now, the opposite of that is the corporation or the Limited Liability Company (we sometimes call that an LLC), and in that case, your exposure is limited, and the reason is this: the law treats a corporation or an LLC as an entity that’s separate from the owner. You’re a shareholder in a corporation, you’re a member of an LLC, and those are different from being the business itself, so for people who are concerned about asset protection, it’s a much better choice to have either a corporation or an LLC, and granted it costs a little more to set these up and there’s a little paperwork involved, but the tradeoff is that you have greater piece of mind. So, that’s one step if you’re going to have an asset protection plan. Another one is, if you can at all help it, don’t sign a personal guarantee for business loans or business credit. Sometimes you don’t have a choice; if you’ve got to borrow money from a bank in order to get started they’re going to want you to guarantee the note, but you try not to do that, or if you must sign a guarantee, see if you can limit its effects; see if you can limit the length of time that it’s going to be in effect, maybe one year or two years rather than indefinitely, and maybe put a cap on your liability. If you’re borrowing $20,000, maybe you’re only going to guarantee $10,000 of it. So, there are ways to try to keep that exposure to a minimum. If you’re going to sign business loans another technique is, don’t have your spouse co-sign the loan. The reason for this is that, in many states, if only one spouse signs the loan, then the creditor can’t go over jointly owned assets. One other thing: you probably shouldn’t pledge your home as collateral for a business debt, because if your business goes bad, you at least want to have a place to live. And probably something else is you of course want to maintain adequate insurance for your business; there are certain risks you can protect against through insurance, and that would also help protect your personal assets.
NOLO: Fred, you mentioned something about not having your spouse sign documents. Do you mean not having your spouse co-sign those documents?
FRED STEINGOLD: Co-sign a loan, particularly. If you’re going to borrow money for your business, it would be better if you sign it in your own name by yourself, and not have your wife as a co-signer, because as I said, in some states, if both spouses sign, then their joint-assets are at risk, their joint-bank account, a jointly-owned home for example, whereas if just one signs, then a creditor can’t go over jointly-owned assets.
NOLO: Fred, in your book you warn against penniless partners. What’s the danger there?
FRED STEINGOLD: Well, if you’re going to go into partnership with somebody or a couple other people and they don’t have any money, and there’s a claim against the partnership and someone gets a judgment, the person who gets a judgment is going to go after whoever they can, and if you’re the one with the deep pockets and the only one with any money, then it’s all going to fall on your shoulders, and if you have a partner who really messes up and really causes the partnership to have big debts, you’re going to be responsible for those debts, and it won’t do you any good to try to turn to the partner to collect from him or her, because we said that they’re without assets; they’re penniless. So, you want to have people in business with you who are on equal financial footing with you.
NOLO: Fred, some people believe that by forming an LLC or a corporation, it creates an automatic shield for their assets. But that’s not always true, correct? There are things like personal guarantees.
FRED STEINGOLD: Right; that’s a very good point. Some people say, “Look, I’ve got a corporation,” or, “I’ve got a Limited Liability Company, so I don’t have to worry; I’m free, I’ve got this great protection.” Well, these are good things to have, because you do get protection, but it’s limited liability; it’s not a complete freedom from liability. For example, you are protected if there’s some debt of the business that you haven’t personally signed, or if one of your employees commits what we call a torte – injures somebody or does something else, you’re protected. As we’ve noted, there are some exceptions: if you sign a debt yourself or personally guarantee one, even though you may have a corporation or an LLC, you still are personally liable for that debt. And then there are your own actions in running the business. Let’s say you send a defamatory letter about a former employee. You can be sued for defamation whether or not you have a corporation. Or, if you engage in sexual harassment, you can be personally liable to the employee who was harassed. So, there are a couple of examples of situations where the corporation can’t protect you, or having a corporation won’t protect you. And, there’s another area, and that is unpaid employment taxes. If you withhold taxes from employees’ paychecks and then don’t pay them and the company goes bankrupt, you’re going to be personally liable for those. And one general point, too, is that you need to follow all the legal formalities for having a corporation or an LLC; you’ve got to maintain the distance between you and the entity, and treat the entity as being separate. If you slip up, then a creditor’s going to say that the entity was just a sham, and in some cases, they can then go after you personally, so you always want to use the correct name of the entity, and you want to sign contracts as an agent of the entity; for example, as a corporate president, or as an LLC member, and that way it’s clear that you’re not personally undertaking liability but only acting as an agent for your entity.
NOLO: As an attorney, how do you deal with a company whose attitude is, “Gee, I should pay my employees first, then I’ll deal with the tax penalties later”?
FRED STEINGOLD: Well, I think if they’re going to do that, they have to be aware that it’s a risky course of action, and if their company stays insolvent, can’t pay its debts and ultimately has to go into bankruptcy, while the other debts may be discharged in bankruptcy, the liability for the employment tax will not, and that burden will fall on the owners; in a small company, particularly, that probably means all the owners, because they’re going to be involved in the day-to-day operations of the business. So, I guess if they’re going to try to cut some corners, they’re going to have to economize in some other way, maybe lay off an employment if necessary, but economize so they can still pay the taxes.
NOLO: Fred, one of the tips we provided earlier was that when a business is in trouble, it should not give preferential treatment to some of its creditors. What’s wrong with that?
FRED STEINGOLD: There’s a legal problem with it; the technical term is “preference among creditors,” and here’s how this works: if your business files for bankruptcy, the bankruptcy judge will scrutinize all the payments you made in the year before you filed for bankruptcy, and if you favor some creditors over others, the judge can order the favored creditors to pay back the money, so that it can then be more equitably spread among all the creditors, and this is especially an area where you have to careful if you’re going to be making any payments to family members or insiders, or transferring business property to them. These payments or transfers are likely going to be undone by a bankruptcy judge, so that’s an area where you should be cautious if your business is getting into financial trouble.
NOLO: Another tip we mentioned earlier – and you also mentioned it in your book – is that when a business is in trouble, it should try to get insurance that extends, and in your book you recommend for at least twelve months. Why is that?
FRED STEINGOLD: For businesses in financial trouble there’s a possibility that you may have to go into bankruptcy, and if that happens, you’re going to have a hard time finding an insurance company that will renew your insurance or issue a new policy. So, you want to try to get some insurance that lasts as long as possible into the future, and as long as you keep making the payments on the premiums, your insurance can’t be cancelled, and this means that your business assets are protected, and that you’ll sleep better at night knowing that.
NOLO: Fred, does it pay for a financially troubled business to get an appraisal?
FRED STEINGOLD: It can help in two situations. One is if you’re thinking of selling the business it could be helpful to be able to know what your assets are worth, but it could also be helpful if you’re trying to negotiate a workout plan with creditors. Then you could show them exactly what the assets are worth, and that will help them make a judgment about whether they want to cooperate with you in trying to keep the business going as long as possible.
NOLO: Last question, what’s a workout, and how do you develop a plan for one?
FRED STEINGOLD: Well, the basic principle is that you’re trying to get all or at least most of the creditors to agree to take a little less of what’s owed, and to give you more time to pay up. But to make this work, you’ve got to be able to convince them that they’ll do better by working with your business and trying to keep it alive than by suing your business or pushing it into bankruptcy, and of course, you’ll need to open your books to the creditors so they know the exact financial condition of the business, and you may have to get help from an experienced accountant to put together a plan that would be palatable to the creditors.
If you’d like to review tips for troubled businesses, check out the Article, “Ten Tips for Financially Troubled Businesses,” at the Nolo website.