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Unveiling the Limits: Does an LLC Truly Shield You From Personal Liability?
When it comes to forming a business, choosing the right structure can be a critical decision with far-reaching implications. One common choice among entrepreneurs is the Limited Liability Company (LLC). The LLC structure is lauded for its flexibility and, most notably, for offering personal liability protection to its members (owners). However, there’s a popular misconception that forming an LLC automatically means your personal assets are entirely off-limits when it comes to business debts and lawsuits. The reality is more nuanced.
The Promise of Limited Liability
The main advantage of forming an LLC is “limited liability,” meaning that the personal assets of the members are generally not at risk for the business’s debts or lawsuits. This is a critical layer of protection that can safeguard your home, personal bank accounts, and other assets in many scenarios. However, this protection is not absolute.
Exceptions to the Rule
Piercing the Corporate Veil
Courts may allow creditors to “pierce the corporate veil” if the LLC is shown to be an alter ego of the owner and not a separate entity. In other words, if the LLC and the individual are not distinct in practice—perhaps because the owner co-mingles personal and business funds, or the LLC is undercapitalized—a court may hold the individual member personally responsible for the business’s liabilities.
In some cases, especially for new LLCs, lenders may require personal guarantees from the members before providing loans or lines of credit to the business. If the LLC defaults on its obligations, the personal guarantor’s assets may be at risk.
Intentional Wrongdoing and Negligence
An LLC doesn’t shield a member from liability for their own intentional misconduct or negligence. If a member is found to have engaged in fraudulent or illegal activities, they can be personally held accountable, irrespective of the LLC structure.
Another common misconception is that an LLC protects the owner from personal tax liability. LLCs are typically “pass-through” entities for tax purposes, meaning that business income and expenses are passed through to the individual members who report this income on their personal tax returns. Therefore, the tax liability is personal and can result in personal assets being used to pay off tax debts if the LLC itself is unable to meet these obligations.
Best Practices for Maintaining Liability Protection
- Separate Finances: Keep your personal and business finances separate to maintain the integrity of the LLC as a distinct entity.
- Adequate Capitalization: Ensure that your LLC is adequately funded, minimizing the risk of it being viewed as a shell or alter ego of the member.
- Follow Formalities: Although LLCs are known for their operational ease compared to corporations, maintaining proper records, and adhering to your LLC’s operating agreement can provide a stronger defense against liability.
- Consult Legal Advice: Always consult a legal advisor when forming an LLC and conducting business to ensure that you are taking the necessary steps to maintain your liability protection.
While forming an LLC offers a valuable layer of liability protection, it is not an invincible shield. Understanding the limitations and taking proactive measures can help ensure that the corporate veil remains intact, offering you the protections you sought when you chose the LLC structure for your business.
Is it true that an LLC doesn’t avoid personal liability? I thought that was the whole point.
Well, a lot of people are under the misconception that an LLC can protect you against all personal liability, but unfortunately, an LLC won’t actually protect you against liability or at least all liability.
Exploring Limited Liability Protection
Let me explain. A limited liability protects you as a shareholder or an owner of the company. So in your role as an owner, you are protected. So let’s say, for example, you own a company, and maybe there are some other owners as well. And those other owners hire a president, and then the president hires other people. As an owner of the company, you absolutely have limited liability. The idea here is that whatever you invest in the company is at risk, but you are not personally liable.
Exceptions to Limited Liability
However, there is a huge exception relevant to most business owners, which I am going to talk about in just a moment. But let me tell you this first, when I was younger, I said, “I think we should abolish corporations. What is the deal with corporations protecting these wrongdoers from liability?” You know, you hear about these big scandals and then the idea that the shareholders or the key people behind the scandal are somehow protected by this corporate shield, this limitation of liability. As you know, an LLC stands for a limited liability company. And it just feels so wrong for somebody who does wrong and uses a business to do it to be protected from personal liability. I mean, don’t we have a country that is founded on the idea of personal responsibility?
Now, I get that that may have eroded over the years. It is a fundamental principle of law that people should be liable for their conduct. And so I thought we should abolish corporations and limited liability companies. Get rid of it. Let’s have everybody be liable for their conduct. Hey, if you work in a business and you do stuff wrong, you are on the hook for it. “These corporate CEOs shouldn’t get off the hook” is what I thought. I still think that, but I no longer believe corporations and LLCs should be abolished.
Understanding Management’s Role in Liability
Here is why. I had a massive misunderstanding of how corporate law and LLC law work. The idea behind a corporation or LLC is that the owner has limited liability because the owner puts money in and has no further involvement. It might have some votes once a year, but that is the owner’s role and owners are protected from liability. But as soon as you get into the role of management or governance of an LLC or a corporation, now you have liability.
So my old flawed thinking was that these corporate CEOs wouldn’t have liability because they were protected by the corporate limited liability shield. But that was totally false. As a business owner, if you are running the company, you have exposure to personal liability. What is this called? And by the way, you might be shocked by this, because a lot of business owners have no idea that they could be liable for the business and what happens in the business.
Negligent Hiring and Its Implications
The first legal doctrine is what is called negligent hiring. And that is when you hire somebody to manage your company without testing them and being careful to make sure they have the capacity to do the job in a proper way, that they have the character required to do it, they have the integrity that they have the qualifications, the skills, perhaps the experience. If you are negligent in hiring a CEO or a president for your company, you can be liable for negligent hiring even though you are just the business owner. You are just the owner. You are not actually running the company.
Now let’s talk about negligent supervision. If you are not adequately supervising the CEO or president of a company as a member of the board of directors or the board of governors or as a shareholder or as an owner of the company, if you are negligent in supervising, you also can have personal liability. So if the company does something wrong or the president does something wrong, they can go after you as an owner. Why? Because you have certain duties that you were negligent in. So this is why it is such a big deal.
Potential Liability as a CEO or President
Now you might say, “Hey, what about if I am not hiring a president or CEO? I am the president or CEO. I have got a little LLC. I just started it.” Maybe you are the only worker in the company. If you are negligent in your duties, you can be liable for your conduct, whether that is hiring other people, or managing other people.
And now here is the problem. Let’s imagine you hire an employee and let’s imagine that employee is being properly supervised by you. But hey, employees are human. They make mistakes. Am I saying that you are going to be liable for that employee’s mistake? Well, that is decided by a judge. And although, generally speaking, you shouldn’t be liable for mistakes like that, keep in mind that you may have an attorney on the other side arguing that you should be liable and now you have to put forward a defense.
Understanding Personal Liability Scenarios
Let me explain how this might look. Imagine that you hire an employee and the employee’s job is to set up the computer system for a hospital. And you are very careful to hire an employee with experience in compliance with data privacy laws related to health documents. And you also regularly supervise the employee. Let’s say you meet with the employee on a daily basis but the employee makes a mistake. And as a result, confidential health information of all of the patients of the hospital are accidentally available to the public and somebody goes and downloads a complete copy and all that stuff ends up on the internet.
Clearly, the company is liable because it made a mistake. There is a question of is the employee liable, but let’s say that the company doesn’t have a lot of assets and so the hospital decides they want to sue you personally. The hospital will try to demonstrate that you failed to act as a reasonable person when managing the employee who did the work and this project. The attorney for the hospital has millions of dollars in interest or motivation to show to a court that you should be liable. Well, what they will go out and do is they will find an expert, somebody in the industry who knows this area of law and how this industry works and they will find an expert who will say a person in your shoes would have been reckless to just rely on one person. There should have been redundancies and double-checks. There should have been a review by somebody else. You should have had a team of experts in different categories who could prevent a massive problem like this from happening. You were well aware that if the data, the patient information was released to the public, it would have devastating consequence on all the patients and the hospital itself so you had an obligation to act as a reasonable person would, a reasonably prudent person would, and prevent something like that from happening by implementing processes and procedures and accountability prior to the release of the data. And so they can sue you personally for negligent supervision of a person or of a project.
And you might say, “Does this really happen?” A number of years ago, the board of Disney, you know, the big children’s movie company was sued and they were sued for not adequately considering the compensation package for their CEO.
Final Advice for Business Owners
So what is the takeaway here? Just keep in mind that as a business owner, you have a risk of personal liability to the customers and clients of your business to anyone who is involved in the business.
Now, practically speaking, what can you do? You can get insurance that can minimize some of that. Of course, being careful with hiring and supervision and all of that and being at the risk is one of the first steps to making sure the team is attentive to those problems and doesn’t let major problems happen. By the way, if major problems happen to you, consider it par for the course. Businesses encounter major problems all the time. If you have 50 employees, you are regularly going to have challenges with employees, and challenges with customers. Being an entrepreneur and a business owner is fantastic. But my job here is to let you know what are some of the risks that are present, and how can you mitigate those risks. You mitigate the risks by hiring good people, setting up good processes, and documenting the processes that you establish. It is not always possible. Of course, as a business owner, you have to decide, Am I going to allocate resources to documenting this to minimize legal problems? Or am I going to spend that time growing the business? There are always these decisions that you make in a business.
So it is absolutely true that a limited liability company does not eliminate your personal liability. It limits it. But if you stay involved in the company, if you continue to run the company, and if you are hiring the employees and establishing systems, you have the risk of personal liability.
Now, practically speaking, what can you do? You can get insurance that can minimize some of that. Of course, being careful with hiring and supervision and all of that and being at the risk is one of the first steps to making sure the team is attentive to those problems and doesn’t let major problems happen.
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I am Aaron Hall, an attorney for business owners and entrepreneurial companies. To learn more about me, please visit aaronhall.com.