Am I Personally Protected if I Form an LLC?
Let me start this post by saying that the law is not black and white. If it were, no one would need to hire lawyers. So, now that we have that out of the way let's get to the topic at hand. Are you and your personal assets protected once you set up an LLC? Let’s take a closer look because, surprise, there is no easy answer.
What Is an LLC?
I am not going to bore you with all of the details (because let's face it, do you really want to know?), instead, here is what you need to know. A Limited Liability Company, (LLC for short), is a business entity that combines elements of a partnership, sole proprietorship, and a corporation.
Most people form an LLC when they open a business to protect themselves from any personal liability if the LLC gets sued or needs to file for bankruptcy protection. The protection provided by an LLC is referred to by us legal types, as the "Corporate Shield."
So, when you set up an LLC you get "shielded" from personal liability. That sounds great. Ok, so what do we know about shields? They worked great to protect ancient armies from direct attacks. Soldiers were able to protect themselves from line-of-sight attacks including, blocking the thrust of a spear, protecting against arrows and defending sword strikes. However, a lone soldier always had to worry about attacks from the rear. Bottom line is that a shield is great, but it's never foolproof. So what do you think this means for the corporate shield? Yup, you guessed it. The corporate shield is great, but it's not foolproof.
Getting Attacked from the Rear
Let's take a closer look at how the owner or principal of an LLC can be exposed to attacks from the rear. By the way, the overly wordy legal term for rear-end exposure (no, not that type of exposure - minds out of the gutter please) is called "Piercing the Corporate Veil." (Damn lawyers and their fancy terms.)
Simply put, in limited circumstances a person or company can pierce the corporate veil, and sue the owner of the LLC personally. Basically, what I am saying is that it is possible for you to be personally liable for certain things even though you have an LLC. Now, before you start to panic, understand that the circumstances are limited.
In general, the courts want the individual business owner to be protected from personal liability. Typically, the only times that a party can pierce the corporate veil or reach you personally is in situations of fraud, illegal activity, or comingling of funds. Ok, so far, this seems pretty straight-forward. But wait, there's more. Yup. it would not be the law if it was straight-forward. If laws were straightforward, how would law schools ever make money?
The Participation Theory
Ok, so there is another doctrine that can expose someone to personal liability even if the corporate veil is not necessarily pierced in the traditinal sense. This separate doctrine is called the "Participation Theory."
Basically, the Participation Theory says that a corporate officer or member of an LLC can be held personally liable for a tort committed by the corporation when he or she is sufficiently involved in the commission of the tort. You are undoubtedly wondering, "What the hell is a tort? And do they come in raspberry?"
According to Cornell Law School, a tort is "an act or omission that gives rise to injury or harm to another and amounts to a civil wrong for which courts impose liability."
To simplify, a tort can be physical or non-physical. For example, if a member of an LLC, punches a customer while negotiating a deal, the corporate shield does not protect him, because he "participated" in a physical tort. Similarly, if an LLC member commits fraud (an intentional non-physical tort), he is also liable under the participation theory.
Moving beyond torts and other baked goods, there are other situations that trigger the participation theory, including violations of the NJ Consumer Fraud Act.
Summing it Up
So, does this mean that you shouldn't bother setting up an LLC or maybe just avoid going into business at all? Of course, not. If you are conducting business you should absolutely form an entity, for example, an LLC. Business is a risk. Hell, crossing the street in New York City is a risk, does that mean you shouldn't do it? Do I even need to answer that one?
What you need to take away from this post is that your rear is always exposed, even when you form an LLC. The best way to protect yourself is to learn about the situations where you can be personally liable and do your damndest to avoid them. For those who you kids from the 80's, remember what GI-Joe used to say, "knowing is half the battle."
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