The Value of a Limited Liability Entity Generally
You have probably heard that you need a limited liability business entity (corporation, LLC, etc.) to protect you from personal liability. There’s a well-known company that runs ads on the radio often. The company provides incorporation services. They’re not a law firm, they just file papers to form corporations and limited liability companies (that may be their exact words, actually!). Their ads sell fear – fear of losing everything if your business is sued and you didn’t set the business up to operate through an entity that provides liability protection.
General partners (in a general partnership or limited partnership, but not the limited partners in a limited partnership) and sole proprietors are subject to personal liability. They don’t have an entity liability shield. This means that if there is an incident in their business that results in a loss or a lawsuit, the owner’s personal assets are at risk.
Corporations and limited liability companies, on the other hand, offer personal liability protection. The liability protection offered by these types of business entities helps ensure that a loss or incident that occurs in your business doesn’t result in exposure to your personal finances and assets. As is always the case in law, there are exceptions (we’ll talk more about those below), although generally speaking, these types of entities will shield you from certain types of personal liability risk.
There are other types of limited liability entities. For example, I am a licensed attorney in Texas and Delaware (Delaware is the hub of corporate law in the United States), and both Texas and Delaware allow founders to create benefit corporations (also sometimes called public benefit corporations). Benefit corporations are a special type of for-profit business favored by social entrepreneurs. Whereas, in a regular for-profit corporation, the officers and directors (on the board of directors) need to always put the interests of the corporation first (a mantra that is sometimes translated as requiring the officers and directors to maximize profit to the shareholders), in a benefit corporation the officers and directors can, actually they must, consider the needs of a particular public group or cause. To read more about benefit corporations, visit Corporate Law Gets Aggressive – All About B Corporations.
Two Main Types of Liability
There are two main types of liability to consider: tort liability and contractual liability.
Contractual liability is incurred when you agree to do something for another person. It includes everything from service contracts in the ordinary course of business to bank loans. To protect yourself, you need to always contract in the name of, and as an agent of, your entity to help ensure protection from contractual liability. You don’t want anyone to get to your personal assets. One caveat is that banks will often require you to personally guarantee your loans (and pledge business assets as collateral). Landlords may also require this in a commercial lease (in fact, they almost always will unless you pay a much higher security deposit or have a very strong business financial statement). However, you should sign your other contracts in the name of the business as often as possible. You do this by listing the company as the signer and using your company title. Do not sign “, individually” or “in his/her personal capacity” or something else along those lines.
Tort liability is incurred because of your tortious action towards another person. I am sure you’re familiar with negligence. The textbook definition of negligence is a failure to act with the level of care that a reasonable person would use under the same 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 a couple other situations – see below). 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.
Potential Liability Even if You Form an LLC or other Limited Liability Entity
Of course, if you form an LLC or corporation in Delaware or Texas (or anywhere else in the U.S. for that matter), you expect the entity to shield you from personally liability. And, if you do things properly (forming the LLC, corporation or other type of entity) and maintaining it properly, it will provide a lot of protection. However, it’s not bulletproof.
To further explain potential liability, the following situations illustrate how members (owners) may be held personally liability for an LLC’s obligations. The same things could happen to shareholders in a corporation or limited partners in a limited partnership:
- 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. Agents or officers may be similarly liable whether or not they are acting on behalf of another or the LLC.
- Members or managers* of a limited liability company may be personally liable if, in their individual capacities, they damage someone else’s contractual or business relationships. For example, if a member makes a down payment under a contract of the LLC to purchase real estate and uses a personal check, and that check bounces, he is personally liable for the bad check.
*Managers of a limited liability company are not what you commonly think of as a manager. “Manager” is a special type of oversight/governance position in an LLC, kind of (not exactly) like directors on a board of directors of a corporation. When you form an LLC, you choose to make it member-managed or manager-managed (when you form an LLC in Delaware, you don’t need to elect to be manager-managed, you can just do it in your Operating Agreement. In Texas, you need to state that the LLC will be manager-managed in the Certificate of Formation you file with the Secretary of State to form the LLC. You are not required to have managers in an LLC in either Delaware or Texas)
- 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, the member should remain insulated by the LLC.
- A member, manager or officer of an LLC may be held personally liable for approving, directing, actively participating in, or contributing to the company’s negligent conduct. Or, under a theory of liability known as negligent hiring (FYI, I don’t handle negligent hiring matters – that’s more in the realm of litigation and I’m a transactional lawyer. However, if you have a question about it, I can recommend another corporation business lawyer in Austin, San Antonio, Houston or Dallas).
- Managers of an LLC, directors of a corporation and sometimes even members of an LLC and shareholders (minor point – in Delaware General Corporation Law, shareholders are called stockholders, although they are called shareholders in Texas – they’re the same thing. Just corporate law being a tiny bit confusing) may be held to a high standard of dealing with others in the LLC (other managers, members, shareholders). Sometimes, depending on the context, one of these people may be deemed to owe fiduciary duties to the others. Fiduciary duties are a high level of care (as a business attorney in Austin, I owe my clients fiduciary duties) – honesty, fairness, confidentiality, prudence, disclosure and good faith (the exact fiduciary duties may vary depending on the position and context).
- Officers and shareholders of corporations, members and managers of LLCs, and limited partners in limited partnerships and limited liability partnerships may be held responsible if the company does not pay certain federal and state tax liabilities. Generally speaking, this will require that the individual had some level of control over filing the tax returns and paying the taxes. If they do, be careful – the taxing authorities have very broad reach to collect taxes and they will go right around the entity to collect from responsible individuals.
There are limited circumstances where the liability shield of a registered legal entity may be pierced and the individuals associated with the entity can be 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. Piercing the veil of an entity will result in liability just like the five “carve-outs” from liability protection we discussed above. The difference, though, is the carve-outs are always a risk, whereas, if you form and maintain a limited entity properly, the veil will not be pierced.
The veil of liability protection provided by an entity may be pierced based on the following theories:
- Alter Ego Theory. If you run your company as little more than your “alter ego,” as a mere extension of yourself (this will generally be the case where there is a lack of separateness between you individually and the company itself, due to commingling of funds, lack of proper governance, and other factors).
- Fraud. The owners of the entity use it as a sham to perpetrate some type of fraud. For example, if you run a business as a corporation and the corporation is sued, you can’t take all its assets and transfer them to a new corporation then shut down the old one, all to avoid responsibility to the plaintiff
- Illegal Purpose. This applies if you form a corporation or other entity to perpetrate an illegal purpose.
To maintain the liability insulation that a limited liability entity provides, take these practical steps:
- Adequately Capitalize the Entity You Form. Adequately capitalize your company (there is no specific required amount. Your company’s specific circumstances, including what types of services or products you sell, will affect what is considered “adequate”).
- Keep Corporate Formalities. Adhere to the corporate formalities set forth in your company’s operating agreement, such as meeting schedules, record keeping requirements, etc.
- Do Not Commingle Assets. Do not commingle the assets of the entity and the members (i.e. separate everyone’s personal money from the business’ money).
- Properly Pay Distribution Pay distributions to members (called dividends when they are paid to stockholders) and other holders of economic rights according to the terms of your bylaws or shareholders agreement (in a corporation), operating agreement (in a limited liability company) or other governing document(s). However, don’t ever make a distribution if, after making the distribution, the company will be unable to pay its liabilities as they come due in the ordinary course of business.
- Regular, Consistent Accounting Practices. Keep a regular, thorough and accurate accounting of the company’s finances.
- Provide Proper Oversight of Officers. Ensure your officers properly perform the tasks delegated to them.
Another Layer of Liability Protection: Business Insurance.
Liability insurance covers risk your business might face, such as accidents and certain types of lawsuits. A basic form of liability insurance is commercial general liability insurance. Professionals (like lawyers and engineers) may carry errors & omissions insurance (also sometimes called professional liability insurance). The types of negligence professionals may be sued for would not be covered under a general liability insurance policy. Talk to a knowledgeable insurance broker to find the right insurance coverage for your business.
The great thing about insurance coverage is that there will be money available to defend and pay a claim. If your business is sued for a significant incident or accident, plaintiff’s lawyers will try desperately to find someone responsible to pay, preferably a person or entity with “deep pockets.” If your business has very little assets or cash, a plaintiff’s lawyer may work extra hard to bring a lawsuit against you personally if there is any possible argument for doing so. Insurance offers a possible solution – an available pool of funds.
Conclusion on Forming LLC or Coporations
Ultimately, there is risk in business as in life. If formed and managed properly, though, a corporation, limited liability company, benefit corporation or other entity can help protect you from some of your business risk and ensure that it’s an acceptable amount of risk relative to the upside in your business. Observing these basic considerations will maximize the likelihood that the benefits and purposes of limited liability will be preserved
Since forming an LLC or corporation or other limited liability entity will not protect you from every possible risk and liability out there, consider business liability insurance. Also, take operational steps to reduce risk, such as implementing strong company policies (including hiring and management policies) and workplace training.
If you have questions about liability protection, forming an entity in Texas, Delaware or anywhere in the U.S. (my website url may say that I am a business attorney in Austin, although with most corporate law matters, physical proximity is not important unless you want it to be), or other questions about business law, please get in touch.
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.