What is Successor Liability and Why Should I Care?

This post about successor liability is prompted by a question that I answered recently on Quora. (See Can I dissolve my corporation and transfer its website to my personal ownership?)

The following is oriented somewhat toward California law, but similar considerations likely apply in other states.

When Successor Liability Typically Arises

Let’s assume that you want to buy an existing business. If your entity purchases the selling entity’s equity interest (corporate shares or LLC membership interests) or merges with that entity, your entity generally will be liable for the seller’s past and future liabilities. See, e.g., Corporations Code Section 1107(a).

For this reason, the purchaser typically creates a separate subsidiary to purchase the existing business. This approach places acquired liabilities in the subsidiary. The existing parent entity is not responsible for those liabilities.

Purchasing Assets to Avoid Successor Liability

Generally, a purchaser can avoid successor liability by purchasing assets of the selling entity, rather than purchasing the entity, itself. But, as is explained below, there are many exceptions that can result in successor liability even in an asset purchase and sale.

This principle is explained by the Supreme Court of California in Ray v. Alad Corp. (emphasis added).

[T]he rule ordinarily applied to the determination of whether a corporation purchasing the principal assets of another corporation assumes the other’s liabilities…states that the purchaser does not assume the seller’s liabilities unless (1) there is an express or implied agreement of assumption, (2) the transaction amounts to a consolidation or merger of the two corporations, (3) the purchasing corporation is a mere continuation of the seller, or (4) the transfer of assets to the purchaser is for the fraudulent purpose of escaping liability for the seller’s debts.

In this case, the court added a fifth basis for successor liability. Strict tort liability for a defective product was imposed, because the purchaser purchased a product line and associated goodwill, and dissolution of the seller meant that plaintiff had no remedy against the seller.

Successor Liability to Governmental Entities

Furthermore, various governmental entities may have claims against the purchaser for amounts not paid by the seller. The following are examples of amounts the purchaser should withhold from the purchase price for payment to the applicable governmental entity. (If amounts are not withheld, the purchaser will become liable for payment of the seller’s obligations.)

• Sales and use taxes – payable to the Board of Equalization.
• Contributions to the California unemployment fund, employment training fund and unemployment compensation disability fund, plus interest and penalties – payable to the Employment Development Department.
• Franchise and income taxes, plus interest and penalties – payable to the Franchise Tax Board.

In summary, if you ever intend to purchase an existing business, take as many actions as possible to minimize the likelihood that you will be subject to successor liability.

Dana H. Shultz, Attorney at Law  +1 510-547-0545  dana [at] danashultz [dot] com
This blog does not provide legal advice and does not create an attorney-client relationship. If you need legal advice, please contact a lawyer directly.