Court of Appeals Ruling Weakens Protection Afforded to Small Business Owners

By: Paul T. McBride

How many small California businesses operate along these lines?

Wayne and Linda, husband and wife, form a limited partnership, Airborne Turbine LP, to operate an airplane leasing business. Wayne and Linda are the limited partners. They form a corporation, Airborne Turbine, Inc., to act as the general partner of Airborne Turbine LP. Wayne and Linda are the sole shareholders and directors of Airborne Turbine, Inc. They are the sole employees of Airborne Turbine LP. They take "draws" from Airborne Turbine LP as needed to pay their personal bills, as the entity is their sole source of income. They hold one pro forma partnership meeting per year.

Many small businesses in California operate along the lines described above, either as limited partnerships or limited liability companies. The owners make their living from the organization while enjoying the shield against personal liability afforded under California law to limited partners ( Corporations Code Section 15903.03(a)) and to members of a limited liability companies ( Corporations Code Section 17703.04). Indeed, it is this shield against personal liability which is the chief attraction of the limited partnership and limited liability company organization forms.

A recent California Court of Appeals ruling substantially weakens the shield against personal liability afforded to limited partners and, by logical extension, to members of limited liability companies. The case is Relentless Air Racing LLC v. Airborne Turbine LP, appearing in the January 3, 2014 edition of the Daily Appellate Report, 2013 WL 6858475. In this case, the Court of Appeals holds that merely paying personal debts from the assets of a limited partnership may be sufficient to lose the shield against personal liability afforded to limited partners.

Relentless Air Racing LLC obtained a judgment of $175,000 against Airborne Turbine LP. Unable to collect the judgment from the limited partnership, it filed a post-judgment motion to have the two limited partners named as judgment debtors. The two limited partners were Wayne and Linda, the couple described above in our introduction. At a post-judgment hearing, Linda testified that the limited partnership was their sole source of income, that they took draws from limited partnership funds as needed to pay their personal obligations, and that they held one pro forma meeting per year.

At the trial level, the judge applied the three-pronged test enunciated in Greenspan v. ADT LLC (2010) 191 Cal.App.4th 486 to determine when a judgment against a limited liability company may be enforced against the personal assets of a member of the limited liability company. That test is: 1) the parties to be added as judgment debtors had control of the underlying litigation and were virtually represented at trial; 2) there is such a unity of interest and ownership that the separate personalities of the entities and the owners no longer exist; and 3) an inequitable result will follow if the acts are treated as those of the entity alone.

Applying this test, the trial judge found that the first two factors were easily satisfied, given that Wayne and Linda were the sole employees of the limited partnership and the sole shareholders of the general partner, and that they took money out of the limited partnership as needed to pay their daily living expenses. However, he ruled that the third factor, an inequitable result, was not satisfied because there was no evidence that Wayne and Linda diverted funds or assets from the limited partnership for the purpose of shielding them from a judgment in favor of the plaintiff. Accordingly, the trial judge denied the motion to have Wayne and Linda added as judgment debtors on the judgment in favor of Relentless Air Racing LLC.

On appeal, the Court of Appeals for the Second Appellate District overturned the trial judge's ruling and entered an order adding Wayne and Linda as co-judgment debtors. In the opinion of the appellate court, whether Wayne and Linda took assets out of the partnership for the purpose of shielding them from creditors was irrelevant. The mere fact that they used partnership assets to pay personal debts, combined with the fact that the partnership had no assets with which to satisfy the judgment, was sufficient to constitute an "inequitable result," in the appellate court's decision.

We expect the Court's decision to be challenged on appeal

In summary, this recent Court of Appeals decision highlights the need for careful planning in business organization formation and conduct. In order to avoid or minimize the risk of having your LLC or limited partnership personal liability shield disregarded, thereby exposing your personal assets, obtaining an annual review and maintenance of your entity documents is recommended. Kring & Chung LLP offers a full range of legal counseling and services related to entity formation and business transactions.

Paul T. McBride is a Partner with Kring & Chung LLP's Sacramento office. He can be contacted at (916) 266-9000 or pmcbride@kringandchung.com.