What a CPA should know before a business fails.

As red ink invades corporate earnings reports, management is showing more interest in such ominous topics as limited liability and its archenemy, piercing the corporate veil. CPAs should, too, because they often are caught in a network of conflicting interests when a business runs into financial trouble.

When a company is threatened with insolvency, CPA@-either as employees of that company or as public accountants serving it as their client-must weigh professional responsibilities that often conflict. One general question they cannot duck: Can they protect the corporation and at the same time protect its principals? Tension between the opposing interests raises difficult legal and ethical issues.

Another concern is CPAS' liability. Although the laws vary from state to state, some aspects of the threat are universal. When a business is in decline, parties at risk typically point fingers at others, seeking to minimize their own loss and liability.

For example, CPAs may be accused of conflict of interest when they try to serve the needs of both the corporation and the -owners. Typically, corporate shareholders may feel that CPAS' advice to pay off an owner-guaranteed loan was not in the best interest of the business. Also, conflict questions may arise when CPAs provide investment advice on the pension assets of a waning corporation.

This article examines the problems that may occur as a business faces financial ruin-especially when the corporate veil is pierced. Once the protection of limited liability is lost, directors, officers and stockholders often find themselves personally liable for a host of obligations and penalties. PERSONAL LOANS AND GUARANTEES Smaller businesses often have trouble getting credit from suppliers or borrowing money. To prime that money pump, corporate principals often must provide personal guarantees.

For example, the head of a company puts up his own home or personal securities as collateral. If the business subsequently experiences financial trouble, the principal, worried that he may be in personal jeopardy if the company eventually goes under, arranges to accelerate repayment of that loan. This move also tends to accelerate the company's slide into insolvency by draining away badly needed cash at a critical time. Thus, while the move may be good for the head of the company, it's not in the best interests of the business.

Also, those accelerated payments may violate other loans and business security agreements. In addition, if the business seems to be moving into bankruptcy, the accelerated payment may be treated as a preference. A creditor must first look to the corporation for satisfaction of the obligation before resorting to the owner-guarantor's property. However, once in bankruptcy, responsibility for payment may be passed on to the guarantors.

WAGES AND OTHER COMPENSATION

Contrary to the limited-liability concept in corporation law, several state legislatures (including Indiana, Michigan, New York, Pennsylvania, Tennessee and Wisconsin) have enacted statutes imposing personal liability on shareholders for wages and salaries owed by a corporation.

Wages and salaries generally include hourly wages or salary, overtime, vacation and severance pay, other fringe benefits and employer contributions to pension or annuity funds.

These statutes are applied narrowly with one aim in mind: to allow workers to collect wages or salaries due if their employer becomes insolvent. The goal is not to make shareholders responsible for all indebtedness of the corporation. If a corporation does business in these states, even if it's not based there, shareholders could be liable for unpaid wages.

Complicating the issue is the fact that state courts have interpreted these statutes in different ways. Originally, the lowest paid employees were the only ones included. Later, some states redefined that to include all "employees." In most cases, these statutes exclude a company's executives, attorneys and independent contractors and their employees.

NEGOTIABLE INSTRUMENTS 

In other matters, too, state laws differ widely on who is personally liable and under what circumstances. For example, corporate principals may be subject to personal liability because of the way they signed corporate checks or other negotiable instruments. Specifically, courts see if the instrument was signed solely in the corporation's name, solely in the name of the person signing the instrument or in some other way.

Liability may also be affected by whether the corporation authorized the individual to sign. Exhibit 1, on page 39, summarizes the rules under the Uniform Commercial Code (UCC) regarding personal liability for negotiable instruments. Under the UCC, a person who transfers a negotiable instrument may face warranty, liability if, for example, he or she endorses a negotiable instrument to a third party. Such an endorsement carries the presumptions that the endorser warranties the original signatures are genuine and the instrument has not been materially altered. If these promises are false, personal liability may result. CPAs should be aware, however, the UCC does not address all possible forms of signature and there are variations in laws from state to state.

TAX LIABILITY

Federal and state tax laws may impose personal liability on certain corporate principals for taxes withheld or collected from others. Under federal law, officers and employees of a corporation are liable for Social Security and federal income taxes withheld from employees' wages. This money is called trust' fund taxes. Many states have similar laws requiring employers to withhold state income tax from wages. Also, liability may be imposed for other types of taxes, such as sales tax, collected from third parties.

As a practical matter, corporations failing to make timely federal tax payments are frequently remiss on state levies, too. While this article focuses on the federal rules, accountants should be alert to the additional possibility of state tax liability.

Corporate officers and employees are not personally liable for the employer's portion of Social Security or unemployment tax obligations; the corporation is. When a corporation fails to turn over withholding and other taxes, however, some corporate officers may face criminal penalties. For example, failure to separately account for withheld taxes, after notice from the IRS, is a misdemeanor. A "willful failure" to "collect, truthfully account for and pay over" tax is a felony. Both are punishable by fines or imprisonment, or both. Such sentences have been levied against officers of delinquent corporations.

The tax law lists about 50 penalties, some of which may apply to delinquent trust' fund tax payments. For instance, under Internal Revenue Code section 6656 it levies the smallest penalty, 2%, when the tax payment is not more than five days late. The maximum penalty, 15%, applies when payment is not made within 10 days of an IRS delinquency notice. Penalties can be imposed on both the corporation and its "responsible" officers and employees.

The trust' fund penalty is imposed only on responsible persons." In other words, an employee or officer is not automatically liable for delinquent trust-fund taxes owed by the employer. The IRS will look at many factors, including authority to sign corporate checks, in determining responsible persons. However, the key factor is control: Who gave the order to sign a cheek?

For the trust-fund penalty to apply, the failure to turn over the withheld taxes must be "willful. " Willfulness means only that the failure was voluntary, conscious and intentional"; a dishonorable motive need not be shown. For instance, a bookkeeper who endorses checks to creditors and knows withheld employment taxes are due would be held to have acted willfully.

Trap to avoid: An employer who makes a voluntary payment of delinquent employment taxes is allowed to designate whether the payment is to reduce either the trust fund or the employer's nontrust fund portion of the delinquent taxes. If the employer does not direct the late payment to either fund, the IRS will deposit the money in the nontrust fund, and that increases the potential personal liability of corporate officers and responsible employees.

Obviously, the best strategy for counseling a financially troubled business is to stay current with all trust-fund obligations. If a business is unable to satisfy all its federal tax liabilities, a voluntary, designated payment of the trust-fund taxes should be made. Similarly, it's usually advisable to direct state tax payments to a particular obligation-one that lowers personal liability.

In practice, once the IRS begins to impose personal liability, some corporate officers try to characterize other colleagues as "responsible persons. " This can occur either during the IRS investigation or after one individual has paid the penalty.

Civil courts rarely allow those who are subject to the trust-fund penalties or who have paid their fines to sue other corporate principals for reimbursement or damages.

LIABILITY FOR PENSIONS

Accountants should give careful attention to the pension area. Compliance requirements are complex and strict. Further, there are provisions in the Employee Retirement Income Security Act of 1974 (ERISA) and other legislation that can pierce the corporate veil. As a result, corporate officers and shareholders may be surprised to discover that their protection from personal liability vanishes, even when they are conscientiously trying to satisfy their legal responsibilities. Liability exists both under ERISA because of fiduciary responsibilities and under the Internal Revenue Code because of the prohibited transactions rules.

ERISA requires a fiduciary to give priority to protecting plan benefits and defraying administrative expenses. There are many rules regarding fiduciary conduct. The definition of fiduciary under ERISA is very broad. Individuals are considered fiduciaries if they can exercise any discretionary authority or control over the administration, management or assets of the pension plan. That includes persons who give or have the authority to give investment advice for direct or indirect compensation. Fiduciary liability is far-reaching. For example, under ERISA, an employer-fiduciary who uses plan assets to finance business operations is personally liable to restore any profits made through the use of those assets. Under the Fair Labor Standards Act, a fiduciary may be subject to liability for delinquent contributions as an "employer." Also, the tax law provisions of ERISA impose penalties on fiduciaries, and under the Internal RevenUE! Code, an employer who lends money to someone who provided services to the plan (a prohibited transaction) would be subjected to fines.

A fiduciary also can be held liable for the actions of a cofiduciary if the fiduciary knowingly participates in or conceals a violation, has knowledge of a violation or enables the cofiduciary to commit a violation. Fiduciaries remain personally liable for delegated activities performed by their agents.

ERISA strikes down exculpatory provisions in a pension plan intended to relieve a fiduciary of responsibility. Insurance may be purchased to cover the fiduciary's liability, but if the insurance is bought by the plan itself, the insurance company has subrogation rights against the insured.

Prohibited transactions refer to certain transactions between the plan and the "parties in interest. " A party in interest includes

* Any fiduciary or person providing services to the plan.

* Any plan, employer, organization or owner with 50% or more business interest.

* Any relative of those previously mentioned.

* An employer, officer, director or person having 10% or more of the interest in any of the above.

Prohibited transactions between the plan and a party in interest include

* Sale, exchange or lease of property.

* Lending money or extending credit (including funding the plan by contributing debt securities).

* Furnishing goods, services or facilities.

* Transferring or using plan assets.

* Acquiring qualifying employer securities and real property in excess of allowable limits.

Also a fiduciary cannot deal with assets in his own interest, act on behalf of anyone having an adverse interest or receive any personal consideration from any party dealing with the plan.

Violate these rules and the IRS levies a penalty of 5% of the amount of the prohibited transaction. If the situation is not corrected within 90 days, the fine is 100%.

ERISA provides for strong enforcement and penalties, too. Some examples are shown in exhibit 2, at left.

Because of the complexity of retirement plan work, many advisers pay scant attention to the further complications of fiduciary liability and personal risk. Of course, that's a serious mistake. The laws are very strict and not necessarily sympathetic to violators--even if good faith efforts are shown. An action taken in good faith can still be interpreted as a breach of fiduciary responsibility or may be treated as a prohibited transaction, resulting in personal liability. Laws concerning pension liabilities apply to an employee and either a shareholder, officer or plan administrator. RECOMMENDATIONS The following guidelines can help accountants act prudently when counseling a troubled business:

* Accountants should focus on the entity represented-the corporation or its principals. The engagement letter should spell out that focus, to avoid conflict of interest.

* Knowledge of state law is especially important, particularly concerning negotiable instruments, wages and taxes.

* A review of loan and guarantee documents also is important to determine what liability may arise under these agreements.

* Accountants should review corporate payroll procedures and compliance to be sure that trust-fund taxes are current.

* Accountants should obtain the necessary expertise to handle any retirement plan issues that arise.

Clearly, traps are set when a business fails. Many acts by corporate directors, stockholders and employees that may have been perfectly legal before the company slid into financial trouble afterward may result in personal liability. For that reason, CPAs counseling a troubled business must be aware of the federal laws, especially in the areas of pensions and taxes, and be sensitive to any unique provisions of state law that give rise to personal liability. n