You have probably heard you need a limited liability business entity (e.g., corporation, LLC, etc.) to protect you when you run a business. Indeed, one of the most important aspects of corporations and limited liability entities is personal liability protection. Unlike general partnerships and sole proprietorships, corporations and LLCs provide a liability shield for their owners. If you are looking for information about whether to form an LLC or a corporation (generally, for small businesses, an s-corporation), read 4 Things to Know When Deciding Between an LLC or S-Corp.
There are two main types of liability to look out for: contractual liability and tort liability.
Liability from Contracts
Contractual liability is incurred when you obligate yourself or your business to take certain actions. It includes everything from service contracts in the ordinary course of business to bank loans. To protect yourself, you need to always sign contracts in your role with the entity. For example:
Signed: __________________
Name: John D. Smith
Title: President
Be sure it is crystal clear you are signing on behalf of the company, not in your personal name. Do this by always using your official title with the company. For LLCs, this may be Manager or Managing Member or it may be a more traditional corporate officer title, such as President or CEO.
There are limits to how much contractual liability protection you will get from your entity, especially in the early stages of your business. Banks and other lenders will almost always require your personal guarantee. Commercial landlords will also require that you personally guarantee your office or other facility lease (there are steps you can take to minimize the effect of a personal guarantee in an office lease, although it’s nearly impossible to completely remove the landlord requirement to personally guarantee your commercial lease if you are a relatively new business). Over time, as the company grows and the longer you stay in business, you may be able to successfully remove requirements for personal guarantees on these types of documents, although don’t expect it to happen anytime soon.
With other contracts, such as customer and vendor contracts (master service agreements, supply agreements, purchaser orders), if you take the right steps, the entity will give you the contractual liability protection you expect.
Negligence and Other Tort Liability
Tort liability is incurred if you act in a tortious manner towards another person. I am sure you’re familiar with negligence. Negligence is failing to act as a reasonable person would in similar circumstances. Damages resulting from negligence are a tort liability. Your entity will protect your personal assets from tort liability, as long as you are not the person who committed the tortious act (or, in limited circumstances, where it is determined that you committed a different tortious act, such as negligent hiring of the employee). If your employee or agent commits a tort, that employee or agent (and sometimes the entity) might be held liable.
However, you always remain responsible for your own torts. This is one reason I tell solo founders who are launching a service business (e.g., consultants, lawyers, engineers, etc.) that the value of an entity from a personal liability protection is much more limited for them, at least while they are a one-person shop. If you are providing the service and something goes wrong, you can count on being named personally in the lawsuit – in your capacity as an individual, in addition to as an officer/employee of your company. So, there may still be some contractual liability protection for the solo founder service business, but relatively less than for other owners.
Examples of Potential Liability for Owners of Legal Entities
To further explain potential liability, the following situations illustrate how members may be held personally liability for an LLC’s obligations (similar situations exist for shareholders in a corporation):
- If a member has an oral side agreement to reimburse the LLC for payments made on a note, which she signed in her capacity as a member of the LLC, the individual may be held personally liable.
- Members of an LLC who personally participate in tortious conduct (bad acts) of the company may be held personally liable for the consequences of their conduct. An agent or an officer who participates in the commission of a tort is liable whether or not he is acting on behalf of another or the LLC.
- Members or managers may be personally liable if they, in their individual capacities, damage someone else’s contractual or business relationships. If you try to hire away another company’s employee and you know that employee is subject to a non-compete, that may be expose you to tortious interference with contract.
- If a member makes a down payment under a contract of the LLC to purchase real estate and uses a personal check, and if that check bounces, the member will be personally liable for the bad check.
- Even if officers and agents of the company are not participating “hands on” at every step, they may be held personally liable for misconduct. This liability is not based solely on their membership in the LLC. Rather, it is the fact that they are present and participating in the operations of the company while a violation is being committed (either by them or the company) that incurs the liability. The LLC’s members are not, however, always liable for bad acts of another person associated with the company. If an employee commits a tort without approval or knowledge of the member, then the member may remain insulated by the LLC.
- As for negligent conduct, a manager of an LLC may be held personally liable for approving, directing, actively participating in, or cooperating in the company’s negligent conduct.
- An LLC’s officers may be held personally liable if they are acting on behalf of the company, and the company, through bad faith misrepresentation, breaches a contract.
- Members will likely be responsible if the company doesn’t pay certain taxes, such as payroll taxes.
- Owners and officers may be responsible through the doctrine of vicarious liability for violations of certain laws, including insider trading and the Foreign Corrupt Practices Act. As your company grows, it is critical to put robust training and compliance monitoring systems in place.
Piercing the Corporate Veil (When the Liability Shield of an Entity Doesn’t Hold Up)
There are limited circumstances where the liability shield of a registered legal entity may be pierced and the individuals behind that entity held personally accountable. This “piercing” is referred to as piercing the corporate veil. Knowing when this could occur is an important factor in asset protection since a piercing event defeats the central purpose of forming a limited liability entity in the first place. Keep in mind that piercing the veil is a different concept than the carve outs from liability protection we discussed above – personal tort liability never benefits from the shield of an entity, whereas contractual liability (if done right and without a personal guarantee) always benefits from the liability protection of an entity UNLESS the entity veil is pierced.
You may be held personally liable through the following avenues:
- Alter Ego Theory. The company operates as little more than the “alter ego” of the individual (this will generally be the case where there is a lack of separateness between an individual and the company itself, due to commingling of funds, the high degree of control of the individual over the company, and other factors).
- Illegal Purpose. The entity form of the company is used to perpetrate an illegal purpose.
- Fraud. The entity form of the company is a sham used to perpetrate fraud.
- Steps to Take to Ensure Your Business Entity Protects You as Much as Possible
In order to maintain the liability insulation that a limited liability entity offers, there are a number of practical steps you should take to reduce the ability of a plaintiff’s attorney to argue for piercing the veil under the alter ego theory. These steps include:
- Adequate Capitalization. Adequately capitalize your company (there is no specific requirement as to the amount, and both your specific circumstances and that of your company will affect what is considered “adequate” – talk to your attorney or accountant about this one)
- Adhere to Formalities. Adhere to the formalities set forth in your company’s operating agreement or Bylaws, such as meeting schedules, record keeping requirements, etc.
- No Commingling of Assets. Do not commingle the assets of the entity and the assets of the owners (i.e. separate out personal money of the owners from the business’ money).
- Pay Distributions. Pay distributions to owners and other holders of economic rights according to the terms of your governing documents.
- Oversight of Officers. Ensure your officers properly perform the tasks delegated to them.
- Regular Accounting Practices. Keep a regular accounting of the company’s finances, and be sure the records you keep are separate from the personal records of the owners.
- Obtain Liability Insurance. Liability insurance covers risks your business might face, such as accidents, lawsuits or property damage. In a small company, where the value of liability protection from an entity may be more limited, liability insurance plays a crucial role.
Conclusion
I feel lawyers often oversell the value of liability protection for small companies, especially small service businesses. That said, there is always at least some value in having an entity from a liability protection standpoint. And, that value is especially high in the beginning for businesses with multiple employees/owners or businesses selling products. As a company grows there is even more protection available. You need to take some steps to ensure you get the benefit of the entity liability protection, although given the cost of forming and maintaining an entity versus the possible liability to owners in most businesses, forming an entity for personal liability protection is generally a simple decision for founders with anything more than a nominal budget.
If you are interested in talking about liability protection for your company, forming an LLC, partnership, corporation (c-corporation or s-corporation) or any other business law needs, please get in touch. I have offices in Austin and Houston, Texas (I am licensed in Delaware and Texas), although, depending on what you’re doing, I may be able to help you out no matter where you are in the world.
Author: Brett Cenkus
Brett Cenkus is a business attorney with 18+ years experience based in Austin, Texas. He has worked with a variety of businesses and has clients throughout Texas as well as many technology clients throughout the United States. Brett is a Harvard Law graduate with a sharply seasoned mind and an entrepreneurial heart. As a founder of 6 companies himself, he is especially passionate about helping startups succeed. In 2016 Brett was named the winner in the Individual category for RecognizeGood’s Ethics in Business & Community Award. He offers businesses solutions that are in sync with their culture, goals and values. You can learn more about Brett by visiting the About page on this website.