Doctors are notoriously bad businesspeople. After all, if they were good businesspeople, they would have gone to business school. They did not. Instead, they went to medical school. But many of them (albeit fewer of them than in the “good old days”) run small businesses. After all, that is what a medical practice is. So what do you tell a doctor who comes to you for advice when the business aspects of his or her practice have failed?
“Health” of the Corporate Form
You might be tempted to call a colleague who practices bankruptcy law. But if your colleagues are anything like mine, they will tell you that corporations rarely file for Chapter 7. Why? Because Chapter 7 does not provide a discharge to the company (it does to an individual, but that is another article). And if you file a corporate Chapter 7, a bankruptcy trustee will automatically be appointed, and that bankruptcy trustee will look to see if the bankruptcy estate can assert any claims—including claims against the former owners and managers of the business.
Optimally, your client will want to reorganize under Chapter 11. However, it is important to note that Chapter 7 cases tend to arise when a business tries to reorganize under Chapter 11, fails to do so, and gets “converted” into a Chapter 7. So, under what circumstances might a business fail in its efforts to reorganize under Chapter 11? Presuming the doctor has followed your advice and set up his or her business as a company (whether it is a PC, an LLC, or something else), your first question should be whether he or she respected the corporate form, a foundation of Chapter 11 reorganization for a business. In too many instances, owners of closely held companies fail to do so. They do not hold corporate meetings (and if they do, they do not keep minutes). They do not sign annual consents in lieu of meetings. Sometimes they “forget” to have (or to use) corporate bank accounts and instead comingle the company’s money with their own. Or, worse, they treat the company’s money as their own and pay personal expenses out of the company’s account.
“[W]henever one in control of a corporation uses that control, or uses the corporate assets, to further his or her own personal interests, the fiction of the separate corporate identity may properly be disregarded.” Lomas v. Kravitz, 130 A.3d 107, 126 (Pa. Super. Ct. 2015) (citations omitted). “The classical piercing of the corporate veil is an equitable remedy whereby a court disregards the existence of the corporation to make the corporation’s individual principals and their personal assets liable for the debts of the corporation.” E. Minerals & Chem. Co. v. Mahan, 225 F.3d 330, 333 n.6 (3d Cir. 2000) (citations omitted).
There is a presumption against piercing the corporate veil. See Lomas, 130 A.3d at 126 (citations omitted); see also Germain v. Wisniewski, 2016 WL 4158994, at *2 (W.D. Pa. Aug. 5, 2016); Clientron Corp. v. Devon IT, Inc., 154 F. Supp. 3d 132, 138 (E.D. Pa. 2015); Aetna, Inc. v. Health Diagnostic Labs., Inc., 2015 WL 9460072, at *9 (E.D. Pa. Dec. 28, 2015). However, lawyers and clients should not count on this. Rather, courts “consider the following factors when determining whether to pierce the corporate veil: (1) undercapitalization; (2) failure to adhere to corporate formalities; (3) substantial intermingling of corporate and personal affairs, and (4) use of the corporate form to perpetrate a fraud.” Lomas, 130 A.3d at 126 (citations omitted); see also E. Minerals, 225 F.3d at 333 n.6; Germain, 2016 WL 4158994, at *3; Aetna, 2015 WL 9460072, at *9. Depending on the court, these tests may be applied either strictly or loosely. There is at least some recognition that closely held corporations often “loosely” observe the corporate form. See Clientron Corp. v. Devon IT, Inc., 2016 WL 3973758, at *7 (E.D. Pa. July 22, 2016) (holding that “no federal precedent allows veil piercing when a husband and wife owned business does not strictly adhere to the formalities of major multinational corporations”).
Personal Liability: No Magic Pill to Cure It
Even if the doctor respected the corporate form, the doctor might still be liable for at least some of the company’s debts. For example, it is not unusual for certain creditors, such as a bank, a landlord, or an equipment supplier, to require a small business owner (even if she is a doctor) to sign a personal guarantee. Those creditors require personal guarantees to keep business owners from abandoning the (worthless) company to its creditors.
Additionally, most states have a wage payment and collection law. These laws often impose personal liability on the people at the company who made the decision to pay—or not pay—the employees. See, e.g., Belcufine v. Aloe, 112 F.3d 633, 639 (3d Cir. 1997); Scungio Borst & Assocs. v. 410 Shurs Lane Developers, LLC, 106 A.3d 103, 107–08 (Pa. Super. Ct. 2014).
By providing employees with a statutory remedy to recover wages and other benefits that are contractually due to them against their managing agents or officers, as well as their employers, the legislature intended to give top corporate managers an incentive to use available corporate funds for the payment of wages and benefits rather than for some other purpose. Holding the managers personally liable serves to give them an incentive not to divert funds away from the payments owed to employees.
Scungio, 106 A.3d at 108 (citations omitted).
Perhaps more importantly, “[u]nder the Internal Revenue Code, any individual responsible for the collection of, accounting for, and payment of trust-fund taxes who willfully fails to perform these obligations may be held personally liable for a penalty equal to the amount of the trust-fund taxes owed.” Crisci v. United States, 407 F. App’x 573, 574 (3d Cir. 2010); see also United States v. Gregg, 2013 WL 6498249, at *5 (W.D. Pa. Dec. 11, 2013); 26 U.S.C. § 6672. “Trust-fund taxes are those that employers withhold from employees’ paychecks to account for their income and Social Security taxes.” Crisci, 407 F. App’x at 574 n.2. As a result, if the doctor “forgot” to turn Social Security withholdings over to the government, she would understand what real pain feels like.
“Two conditions must be met before personal liability can attach under 26 U.S.C. § 6672: (1) the individual must be a responsible person, and (2) his or her failure to pay the tax must be willful. . . . Responsibility is a matter of status, duty or authority, not knowledge.” Gregg, 2013 WL 6498249, at *6 (citations omitted).
Factors that courts consider when deciding whether someone is a “responsible person” include
(1) the contents of the corporate bylaws; (2) the ability to signs checks on the company’s bank account; (3) the signature on the corporation’s tax returns; (4) the payment of other creditors; (5) the identity of officers, directors and principal stockholders in the corporations; (6) the identity of individuals in charge of hiring and discharging employees; and (7) the identity of individuals in charge of the firm’s financial affairs.
Id. (citations omitted). “A demonstration of significant, as opposed to absolute or exclusive, control over a company’s finances will suffice to establish status as a responsible person.” In terms of intention, “[w]illfulness exists when the responsible party knows that taxes are due, or acts in reckless disregard of this fact.” Id. (citations omitted).
In addition to being potentially responsible for at least some company debts, the doctor may have to repay distributions that she received from the company. As a general matter, a company cannot make distributions if it is insolvent (or if making that distribution would make the company insolvent). See, e.g., 15 Pa. Cons. Stat. Ann. § 1551(b). “Insolvency” can be measured “under either the ‘equity test’ (unable to pay debts as they become due) or the ‘balance sheet test’ (liabilities exceed assets).” In re Tri-State Telecomms., Inc., 2012 WL 4904537, at *8 (Bankr. E.D. Pa. Oct. 15, 2012) (citations omitted). If the doctor was a director of the company (which almost assuredly will be the case) and the company made distributions to others (such as “junior partners” in the practice), she can also be personally liable for the amounts distributed. Id.
After hearing all of this, the doctor will almost undoubtedly complain that you are not providing him or her comfort or a magic pill to painlessly solve all the doctor’s problems. While you will probably be tempted to ask the doctor how it feels, or point out that at least you did not keep him or her waiting for 30 minutes, you should try and resist that temptation. Among other things, doctors know that pointing out to a patient that they are responsible for their injuries never promotes the healing process.
Aaron Krauss is a commercial litigator who practices with Cozen O’Connor in Philadelphia, Pennsylvania. He is a cochair of the ABA Section of Litigation Health Law Litigation Committee.
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