Does an LLC Always Protect Against Personal Liability?
When you create an LLC, you are creating a separate legal entity. This shields you from personal liability for business debts and obligations. However, there are some cases where you may still be held liable. In this article, we'll explore when an LLC will protect you from personal liability and when it won't. We'll also look at some of the exceptions to this rule.
There is a common belief that when someone forms an LLC, they are always insulated against personal liability. In other words, the common belief is that forming an LLC creates an impenetrable shield that will prevent the member from being sued or having their personal assets at risk.
Over the years, our firm has helped thousands of people create LLCs and has fielded thousands of calls and inquiries concerning LLC formation. Nearly 85% of all the people we have spoken with believe that an LLC protects them personally against liability in all situations. This article will clear up common misconceptions concerning the limits of the protections provided by an LLC and provide additional insight into its benefits concerning personal liability protection.
Nearly 85% of all the people we have spoken with believe that an LLC protects them personally against liability in all situations.
What is the purpose of an LLC
A limited liability company, or LLC, is a business structure that is relatively easy to create, maintain, and amend. In general, an LLC provides the same liability protection that incorporation provides. To keep it simple, an LLC can be considered a 'lite" version of a corporation.
Why is it important to create an LLC?
It is important to create an LLC to separate yourself as an individual from the business entity. One of the most critical aspects of an LLC is the protection provided against personal liability. In other words, if a customer or client sues your LLC, they may only be entitled to a judgment against the LLC and not you personally. This structure allows you to protect your personal assets. While an LLC offers a great deal of protection, it is not foolproof. We will get to the limitations of an LLC's protection later in this post. Before we do, let's look at the difference between a sole proprietorship and an LLC.
A Side Note About Accountants and Business Structure and Liability
Many accountants offer business formation setup services. However, most accountants are not familiar with the legal aspect of business formation or which one might provide you with the most protection against liability. Accountants might be better suited to address tax implications than most lawyers, but they typically do not have the knowledge to advise of liability protection.
While some accountants may be able to provide you with general information about business structures, they should not give you specific legal advice. In fact, it is unethical for an accountant to provide legal advice and may constitute the unauthorized practice of law.
The unauthorized practice of law (UPL) is the term used to describe when a person who is not a licensed attorney provides legal advice or services to clients. This can be a very serious issue as it can lead to clients receiving incorrect information and, in some cases, being taken advantage of financially. UPL can also create ethical issues for accountants. To protect the public, many states have laws in place that prohibit the unauthorized practice of law.
LLC v. Sole Proprietorship
One of the most common misconceptions is that an individual is too small to form an LLC and is better off conducting business as a sole proprietor. A sole proprietorship offers nearly no protection against personal liability. If your business is sued, your personal assets are on the hook as a sole proprietor. Let's look at an example.
Assume you have graphic design skills and enjoy creating logos. You decide that it is time to get paid for your logo-making ability. Since you are the only one involved in the business and have no plans to rent an office space or hire employees, you decide that you should create your business as a sole proprietor. You even go so far as to check with your accountant that a sole proprietorship makes sense for you from a tax perspective, and your accountant gives you their blessing.
You begin creating logos, and you start making some money. A small company then hires you to create a logo for its new products. After you submit your logo to the client, you learn that your client's competitor is making claims that your client's logo contains trademarked elements.
The competitor ultimately sues your client. Since you designed the logo, your client brings you into the lawsuit. Ultimately, your client settles with the competitor for $20,000. Your client then continues to pursue claims against you for indemnification. Eventually, the client prevails, and you are hit with a $20,000 judgment.
Because you are a sole proprietor, the judgment can be enforced against your personal assets; this means that your client can obtain the right to garnish your wages, seize your bank accounts, and place liens on your property. If you had established an LLC, the judgment would have stayed with the LLC, and your personal assets would have been protected.
The bottom line is that there is almost always no situation where acting as a sole proprietor is considered favorable. Instead of operating as a sole proprietorship, anyone seeking to do business, even if it is just you and you have no plans of bringing on employees, should set up an LLC to protect themselves.
An LLC Sounds Great. So, What's the Problem?
Overall, an LLC does a great job separating the business from the people who own it. There is no problem with an LLC. What is problematic is the common misconception that the LLC will always, in all circumstances, protect an individual from liability. Knowing more about the situations where an LLC does not protect you from personal liability can help you further protect your assets as you operate and grow your business.
Knowing more about the situations where an LLC does not protect you from personal liability can help you further protect your assets as you operate and grow your business.
When Does an LLC Not Protect You From Personal Liability?
In general, there are two ways that your personal assets can become exposed even though you operate your business as an LLC. Let's look at both of those ways in greater detail.
(1) Piercing the Corporate Veil
Most people have heard the phrase piercing the corporate veil. While it seems like it is something that might happen on an episode of Game of Thrones or some other medieval drama, the corporate veil can be pierced when a business is sued, and the owner(s) of the LLC do not treat the LLC as a separate legal entity. This means they commingle personal and business assets, don't follow corporate formalities, or transfer company assets individually.
Another way that the corporate veil can be pierced is when the entity is not properly formed. This means that the LLC did not file the correct paperwork with the state, or the LLC has been terminated, but the owners have not properly filed to wind up the company. In this situation, the court may "pierce the veil" and hold the owners of the LLC liable for company debts and obligations.
Protection Against Piercing the Corporate Veil
The best way to protect yourself from personal liability is to always operate your business as an LLC and ensure that you follow all corporate formalities. Suppose you are ever unsure about whether something you are doing would be considered commingling assets or not. In that case, it is always best to speak with an attorney.
(2) Tort Participation Theory
Just about all of the states in the U.S. have a version of the Tort Participation Theory (TPT.) The TPT is an often-overlooked mechanism by which your personal assets can become exposed even when operating your business as an LLC.
In general, the tort participation theory is a legal principle that holds an owner of a company liable for the company's torts (wrongful acts). This means that even if you are not the one who committed the tort, you can be held liable as an owner of the company.
There are four elements that must be met for the tort participation theory to apply:
The company must commit a tort
The company must have an owner or owners
The owner or owners must participate in the commission of the tort
The owner or owners must be liable for the tort
All four elements must be met for the tort participation theory to apply. If even one of these elements is not met, you cannot be held liable as an owner of the company.
New Jersey Tort Participation Theory
Under New Jersey Law, the essence of the participation theory is that a corporate officer can be held personally liable for a tort committed by the corporation when they are sufficiently involved in the commission of the tort. A predicate to liability is a finding that the corporation owed a duty of care to the victim, the duty was delegated to the officer, and the officer breached the duty of care by his own conduct.
New Jersey cases that have applied the participation theory to hold corporate officers personally responsible for their tortious conduct generally have involved intentional torts. More specifically, the majority of the cases have involved fraud and conversion. See, e.g., Charles Bloom Co. v. Echo Jewelers, 279 N.J. Super., 372, 382 (App. Div. 1995) (holding that defendants could be personally liable for alleged conversion even if they were acting in corporate capacity); Van Dam Egg Co. v. Allendale Farms, 199 N.J. Super. 452, 457 (App.Div. 198 5) (declining to dismiss fraud complaint against corporate officer even though it did not allege that he personally benefitted from allegedly wrongful acts); Robsac Indus., Inc. v. Chartpak, 204 N.J. Super. 149, 156 (App.Div. 1985) (reversing summary judgment for defendant corporate officer charged with malicious interference with contract, fraudulent misrepresentation, and defamation notwithstanding that liability also was imposed on corporation); McGlynn v. Schultz, 95 N.J. Super. 412, 417 (App.Div. 1967) (finding corporate officers personally liable for knowingly acquiescing in and ratifying alleged conversion).
What is a Tort?
A tort is a wrongful act or injury, especially one committed against the person or property of another. The word "tort" derives from Old French and Latin words meaning "wrongful act." A tort can be considered a civil wrong (i.e., personal injury) or refer to criminal wrongdoing.
The law often classifies torts into three categories: intentional torts (or trespass), negligence, and strict liability offenses. Intentional torts are those in which the defendant intentionally damages someone else's interests; this includes assault, battery, false imprisonment, invasion of privacy, defamation (libel), fraud (which generally requires some degree of intent to deceive), conversion/theft, and malicious prosecution.
Negligence is the failure to exercise the degree of care that a reasonably prudent person would in similar circumstances, while strict liability offenses are those where the defendant is liable regardless of fault (such as product liability).
Protection Against Tort Participation Claims
With respect to protecting against Tort Participation Theory claims, it is important that you take an active role in overseeing what your employees or other members are doing with the business. If you are the only member of the LLC, it is relatively simple to protect against the torrent participation theory. Be honest and transparent, do not engage in fraudulent conduct, be aware of statutes like the consumer fraud act, and hold yourself in your business to high morale and ethical standards.
What About Insurance? Is there anything else I can do?
As a further measure over your personal assets, you can look into insurance as a means of providing additional protection and covering certain claims and legal fees.
If you ask fellow business owners, family members, or even an insurance broker what type of insurance you need, they will almost always tell you to purchase a Commercial General Liability policy (CGL.)
What is a general commercial liability policy or CGL?
A general commercial liability policy is a type of insurance that provides coverage for third-party claims made against your business. This type of policy is designed to protect you from a wide range of potential liabilities, such as injuries that occur on your premises, libel or slander, product liability, and contractual liability. Most CGL policies also provide coverage for lost income and the costs associated with defending against a lawsuit.
It is important to note that a CGL policy does not protect against all types of losses. For example, it will not cover damages that result from an employee's intentional act or criminal act.
More often than not, a general commercial liability policy will not protect you against claims of professional negligence, errors, or omissions. While it is generally necessary to carry a Commercial General Liability policy, you should look into obtaining additional coverage through either Directors and Officers coverage or Errors and Omissions endorsement.