Proprietor Beware: Corporate Refuge Can Ensnare

In theory at least, business owners incorporate (or form similar entities) to limit personal risk.  However, these precautions mostly don’t affect tort exposures like negligence (hence, one still needs insurance), and the touted benefit is nil if the principal blithely guaranties the company’s significant obligations.  Worse, the extra structural layer can cause mischief beyond pointless red tape:  If the business fails and oppressive debt flows through, the shareholder can face more grief than a sole proprietor would.

Below we touch on several such pitfalls.  As explained, financially distressed proprietors likely have better protection on debts secured by real estate, they have more leeway to use scarce resources for personal needs, and they are probably freer to decide which debts to pay first.  While the corporate form can also have countervailing advantages (with or without buffered liability), weighing the pros and cons likely requires 20/20 hindsight.

No Trust Deed Shields

Many California lawyers know that three’s often a crowd in borrowing against real property.  When a loan is secured by realty, the state’s “one form of action” and antideficiciency rules afford a measure of insulation for those whose performance is backed by the mortgage or deed of trust.  See Cal. Code Civ. Proc. (“CCP”) §§ 580d, 726.  On default, the lender cannot merely sue for breach of a promissory note, but must either resort to a cumbersome judicial foreclosure action or elect nonjudicial foreclosure under a power of sale.  The latter is far more common in practice, and a trust deed beneficiary who takes that route forfeits contractual recourse to the trustor-borrower for any shortfall in the foreclosure proceeds.  Thus, if I use my own land as security and things go sideways, I can easily lose the property, but (assuming no sold-out junior liens) I probably won’t face residual claims against unencumbered assets or my future earnings.

The plot thickens if my corporation owns the building and borrows the money, but—as is typical—the bank insists on my guaranty, fortified by all that boilerplate text disavowing suretyship defenses.  See Cal. Civ. Code (“Civ.”) § 2856 (validating expansive waivers).  Assuming the guaranty is unsecured and genuine (not a sham contrived to defeat the trust deed financing constraints, see Union Bank v. Brummell, 269 Cal. App. 2d 836, 838 (1969)), my failure to honor a proper demand means the bank can immediately sue for breach—no need to look to the security first or to struggle through judicial foreclosure.  See Martin v. Becker, 169 Cal. 301, 306-307 (1915).  Further, even if the bank begins with a nonjudicial foreclosure, the guaranty’s standard “Gradsky” waiver means I’ll have no antideficiency armor.  Glendale Fed. Sav. & Loan Ass’n v. Marina View Heights Dev. Co., 66 Cal. App. 3d 101, 154 (1977).  In other words, at least from this perspective, I’ve outsmarted myself in choosing to borrow via the corporation.

Personal Asset Use as Fraudulent

  Transfers to hinder, delay, or defraud creditors are improper, and – even if intent is benign – an insolvent’s transfer for less than reasonably equivalent value in exchange is voidable.  See Civ. §§ 3439-3439.08.  However, as a proprietor on the ropes, I could still presumably use business revenues to meet my own living expenses, because the money belongs to me, and buying groceries wouldn’t readily be cast as a fraud on creditors even though it would deplete my leviable assets.

But if I’ve incorporated the business, I’m just the stockholder, and the company can only make distributions on account of equity if it can cover its debts.  See Cal. Corp. Code §§ 500, 501.  In using cash to buy my groceries, I’m initially making a transfer from the corporate coffers to myself and—positing that the company is insolvent—this would be improper and at least constructively fraudulent unless I’m contributing reasonably equivalent value in exchange.  While I might be providing services for which a fair wage is appropriate, that’s a question of fact (and there’s also the extra freight of payroll taxes to consider).  If I’m not currently working for the company, then drawing dollars out to support my family may be pretty dicey.

A misstep here could have serious consequences.  Improper distribution would effectively siphon off funds reserved for creditors and—if considered a “willful and malicious injury” to another’s property, within the meaning of 11 U.S.C. (“BK”) § 523(a)(6)—my liability could be excepted from any discharge I get through personal bankruptcy.  See Nahman v. Jacks (In re Jacks), 266 B.R. 728, 740-43 (Bankr. 9th Cir. 2001).  Still more foreboding, a determination that I took corporate funds knowing this would prejudice creditors could establish that I intended to hinder, delay, or defraud them.  If both the company and I then wind up in bankruptcy within a year thereafter, my entire personal discharge could be denied as a result.  See Redmond v. Karr (In re Karr), 442 B.R. 785, 796-98 (Bankr. D. Kan. 2011) (applying BK § 727(a)(7)).  Again, by contrast, a proprietor consuming funds for food and rent would face no comparable jeopardy.

Restraint on Preferential Payments

Outside the bankruptcy context, debtors generally can pay valid claims in whatever sequence they choose, even when there’s not enough to go around, see Civ. § 3432, and this ordinarily wouldn’t constitute a fraudulent transfer.  See Wyzard v. Goller, 23 Cal. App. 4th 1183, 1188-91 (1994).  However, once a corporation is insolvent, California recognizes a “trust fund doctrine” whereby the company’s assets are held for the benefit of all creditors, and management mustn’t pay insider claims preferentially.  See Commons v. Schine, 35 Cal. App. 3d 141, 144-45 (1973).  There is even authority suggesting that an officer may be liable for preferring an outsider.  See Saracco Tank & Welding Co. v. Platz, 65 Cal. App. 2d 306, 315-16 (1944).

So suppose that the creditors of my failed enterprise include my brother, a bank that says my loan application was misleading (so that this debt could be bankruptcy-resistant under BK § 523(a)(2)), and several vendors with whom I hope to do business again in a future venture.  As a proprietor, there’s little doubt that I can choose to pay these debts first (thereby forestalling family feuds, curtailing a potentially nondischargeable exposure, and keeping faith with those prospective suppliers), and the transfers will stick unless I’m in a bankruptcy within the “preference” reachback window (a full year for my “insider” sibling, but in this setting only 90 days for the bank or the vendors).  See BK § 547(b)(4).

Now suppose the business is incorporated and the trust fund doctrine is triggered.  As the guy in charge, I almost certainly couldn’t pay my own claims ahead of others, and in favoring my brother, the bank, and key vendors, I would do much the same thing—I would pick them to maximize the personal benefit I get from satisfying their claims first.  Thus, a California court might well say I’m personally liable to the disadvantaged creditors for the funds so diverted.

But, so what?  If I was already obliged on guaranties, or if I would have been directly bound anyway as a proprietor, aren’t we dealing with the very same debt?  Not necessarily:  Some cases hold that—as a trustee of the insolvent company’s assets who disbursed them preferentially—I would have committed “defalcation” in a fiduciary capacity, and that could easily make any resulting liability nondischargeable in my personal bankruptcy.  See Nahman v. Jacks (In re Jacks), 266 B.R. 728, 736 (Bankr. 9th Cir. 2001) (citing BK § 523(a)(4)).  In other words, at least to the extent of the same strategic preferences I could have conferred with impunity as a proprietor, I may now have saddled myself with unshakable debt.  But see Swimmer v. Moeller (In re Moeller), No. 11-90207-LT, 2012 Bankr. LEXIS 1202 (Bankr. S.D. Cal. Mar. 5, 2012) (trust fund doctrine doesn’t create express or technical trust required for defalcation liability).

Upside Offsets

Of course, the corporate form can have advantages apart from redirecting liability.  Some examples:

• While there’s no obvious, legitimate way to shield proprietorship cash from a judgment creditor, the company could properly pay me a reasonable wage for services rendered, and the regular 25% garnishment limit should apply to those earnings.  CCP § 706.050 (incorporating disposable earnings restriction of 15 U.S.C. § 1673(a)); cf. Carter v. Anderson (In re Carter), 182 F.3d 1027 (9th Cir. 1999) (CCP § 704.070’s correlative 30-day exemption for 75% of paid earnings traceable into deposit account is available to sole director-shareholder of “S” corporation).
• Similarly, although California only recognizes a qualified exemption—covering amounts “necessary” for the debtor and dependents’ projected future “support”—as to a self-employed retirement plan or an individual retirement account, see CCP § 704.115(e), funds held in a plan sponsored by my close corporation should be fully exempt, even though I am the company.  See Cheng v. Gill (In re Cheng), 943 F.2d 1114, 1116-17 (9th Cir. 1991).  (This benefit is currently less important if I file personal bankruptcy, since I can likely exempt $1,171,650 in IRA or Keogh funds under BK § 522(b)(3)(C) and (n).)
• If my proprietorship is still “kicking” but has little or no sale value, I might want to pursue a simple chapter 7 discharge while continuing the business, perhaps my only source of income.  Unfortunately, a chapter 7 debtor can’t use estate assets for ongoing operations.  See In re Gracey, 80 B.R. 675, 678 (E.D. Pa. 1987), aff’d, 849 F.2d 601 (3d Cir.), cert. denied, 488 U.S. 880 (1988).  And because chapter 7 trustees are responsible for estate property and obliged to liquidate it expeditiously, see BK § 704(a)(1)-(2), they usually demand that all business activity cease (though a trustee theoretically could operate with leave under section 721).  However, if I’ve incorporated and the company doesn’t file bankruptcy, my own chapter 7 petition needn’t disrupt the enterprise (and the trustee would rarely give a hoot unless my stock had unencumbered, nonexempt value).  (Note, though, that an eve-of-bankruptcy incorporation is hazardous if it harms creditors.  See Emmett Valley Assocs. v. Woodfield (In re Woodfield), 978 F.2d 516 (9th Cir. 1992) (discharge denied for fraudulent intent).)

Upshot?

Only clairvoyance could foretell up front how all this will play out if a business falters.  However, inasmuch as incorporation plainly could backfire, and since an artificial entity inherently complicates life, most folks probably should remain sole proprietors unless there’s good reason to depart from the basic model.  Given that sophisticated creditors frequently require a guaranty anyway, the imagined escape from personal exposure in and of itself probably doesn’t justify incorporating for the average small fry.

David Katzen practices with Katzen & Schuricht in Walnut Creek and has concentrated on representing parties in the insolvency context for over 30 years.  He is recognized by the State Bar of California Board of Legal Specialization as a Certified Specialist in Bankruptcy Law and is also Board Certified in Business Bankruptcy Law by the American Board of Certification.