This strategy can be very effective. Suppose that “Charles” has invented a new type of desk chair and he has received a patent for it. He wants to start making them, but is afraid that if one breaks and someone is hurt, he will be sued. So he creates a company with his friend “Danny,” Charles’ Chairs Inc., where they are the sole shareholders. Since the only real asset that Charles’ Chairs Inc., would have is the patent, instead of assigning the patent to Charles’ Chairs, he creates another company, Charles’ Patents LLC, and assigns the patent to it. Charles is the sole member of Charles’ Patents LLC.
If anyone buys a Charles Chair and is hurt, the only “person” to sue is Charles’ Chairs Inc., which has almost no assets – just some inventory, but probably a lot of accounts payable and debt. This is all perfectly reasonable and ethical behavior.
But while the creation of the companies protects them individually from some things, it does not protect them from others. For instance, it is very unlikely that anyone (including banks and credit card companies) will extend any credit to Charles’ Chairs Inc., unless Charles or Danny, or both, guarantee repayment.
Unfortunately, all too frequently, while creating these companies is a great idea, the execution of his idea – that is, putting it into practice – may be a problem. Assume that Charles doesn’t try to set up the companies himself, but has his lawyer do it. The lawyer creates the corporation and the limited liability company; his bookkeeper or accountant gets their tax identification numbers and sets up systems to pay necessary taxes. Too many people stop there.
Charles’ Chairs Inc. needs a license from Charles’ Patents LLC to make the chairs. If it doesn’t get one, it may be infringing the patent when it makes the chairs. If, during the manufacture of the chairs, Danny discovers ways to improve the chair, who will own those improvements? Charles’ Chairs Inc.? Or Charles’ Patents LLC? Or Danny? Without a written license agreement, and a written agreement between Danny and Charles’ Chairs Inc. and between Charles and Charles’ Chairs Inc., answering the question could be quite complex.
Furthermore, who can authorize the license? Not Charles; the patent is not his. Only Charles’ Patents LLC can do it. So, we need a resolution of the members of Charles’ Patents LLC. We need regular meetings of the shareholders or board of directors of Charles’ Chairs Inc., to review and approve activities; and, of members (even though there is only one) of Charles’ Patents LLC. Moreover, we need written records of the meetings. The meetings need not be overly formal. If the entities are really separate, they need to be treated as separate. Separate bank accounts, separate websites, separate secretary of state registrations, separate names, regular meetings, and complete records.
In the press of business, it seems a little foppish to have meetings of one member or meetings of two shareholders; to write formal minutes and resolutions. However, if Charles and Danny do not follow the formalities, it may do them no good to have gone to the trouble to create these companies.
The reader may think that this is something only seen in very small companies – one to five members or shareholders. Certainly those folks need to go back and look at whether they are complying with formalities. But they’re not the only ones. If you are a principal in a medium-size business, take a look at your business records. Unless you have been very diligent and had people you rely on taking care of your records, I’ll bet you a cinnamon roll at the Silver Grill Café that I can find some problems. Even minor problems or omissions could cost you a lot of money, stress and aggravation.
You may be able to extricate yourself and your co-shareholders or co-members from personal liability, or shield one company from attack. But it may cost more to do that than to clean up your records.
It’s tax season, you are supposed to be miserable; so, while you are miserable anyway, clean up your records. It’s not that hard, it’s just tedious; but it’s worth it.
Alan F. Blakley is a lawyer with CR MILES P.C. in Fort Collins. He can be reached at firstname.lastname@example.org.