How Limited is Limited Liability?

One of the key advantages of a limited liability company (LLC) over a sole proprietorship or general partnership is the fact that the owners (members) of the LLC are not personally liable for the debts and claims of the business. Normally, that means that if the business is unable to pay a supplier, lender, landlord or other creditor, that person cannot go after the personal assets of the members of the LLC. The members may lose their entire investment in the business, but their other assets – car, home, and personal bank accounts – are safe from the creditors of the business.

Or are they? In truth, there are many exceptions to the rule of limited liability. Many LLC members will find that, due to the way the business was operated, the promised protection from the liabilities and claims of the business is not meaningful.

How Personal Liability Arises

A member of an LLC can be held personally liable for many different types of claims, but they typically arise under four different scenarios:

  • Claims arising out of an act or omission by the member, such as the member’s own negligence, fraud or illegal act
  • Claims arising out of a contract, particularly one that was personally guaranteed by the member
  • Claims based on the concept of “piercing the veil” of the LLC
  • Liability for consenting to or receiving a distribution in violation of the LLC’s operating agreement or the applicable LLC statute

These claims are not a result of choosing an LLC as a form of entity. All of these exceptions apply equally to shareholders in corporations and, in fact, the exceptions were developed first under corporate law.

Actions of a Member

Every member who actively participates in the business of the LLC runs the risk that his action or inaction will result in personal liability. This is particularly a risk of a service business in which the members provide the key service. If you are an electrician and you leave an exposed wire that electrocutes someone, your LLC is not going to protect you.

Similarly, if you make promises about your product or service that are not true, the first claim may be against the LLC for breach of contract, but if the LLC cannot perform or pay damages, the injured party may come after you for fraud or a similar claim based upon your own action.

Even if you have an employee who committed the action, you may not be out of the woods. If you personally hired the employee, the injured party may have a claim against you for negligent hiring if a reasonable person would not have hired that employee.

A special category of personal liability that may trip up a member of an LLC is failure to pay payroll taxes to the IRS. To protect these so-called “trust fund taxes,” any person who had the ability to prevent the non-payment can be personally liable for the failure to pay these taxes. The IRS applies this provision broadly, so if you had power to direct which bills got paid and which didn’t, you are probably liable.

Claims Based on Contract

Another, and probably more common, source of personal liability for many small business owners is the voluntary assumption of liability, usually by means of a personal guarantee. For many small businesses, particularly new businesses with no credit history, obtaining a loan without a personal guarantee is virtually impossible. Landlords, too, often insist on a personal guarantee, particularly if the lease requires the landlord to incur costs such as build-outs that it expects to recoup over the term of the lease.

Suppliers are sometimes more flexible on extending credit, especially after the business is up and running. Getting payment terms out of the gate, however, often requires a personal guarantee.

Even when the creditor isn’t seeking a personal guarantee, a member of the LLC can inadvertently become a party to the contract by failing to clearly note his role. If she signs her own name and does not indicate that she is executing the contract on behalf of the LLC, it is very likely that a court will hold her responsible for the contract. Every contract should clearly indicate that the party to the contract is the LLC (full name!) and should indicate the role of the person who is signing (member or manager).

Piercing the Veil of the LLC

Even if a member avoids personal guarantees, he may find himself liable to creditors of the business under a theory developed under corporate law and known as “piercing the corporate veil.” Although the factors that courts look at vary to some extent from jurisdiction to jurisdiction, the courts typically look at whether there is a unity of interest and ownership such that the separate personalities of the entity and the owner no longer exists and whether to respect the distinction between the owner and the entity would be an injustice.

In almost all cases of piercing the veil, there is either commingling or diversion of assets. Some other facts that courts examine in corporate cases include:

  • Inadequate capitalization
  • Failure to issue stock
  • Failure to observe corporate formalities
  • Nonpayment of dividends
  • Insolvency of the debtor corporation at the time
  • Non-functioning of other officers or directors
  • Absence of corporate records
  • Commingling of funds
  • Diversion of assets
  • Failure to maintain arm’s length relationships among related entities
  • Whether the corporation is a mere facade for the operation of the dominant shareholders

A possible benefit of an LLC over a corporation is that several of the commonly listed factors (failure to issue stock, failure to observe corporate formalities, and absence of corporate records) have no real counterparts in an LLC. However, as case law develops, the absence of those factors may simply shift emphasis on some of the other factors.

Distributions in Violation of Law or Agreement

LLC Acts typically prohibit an LLC from making certain distributions. For example, the final draft of the Revised Uniform Limited Liability Company Act provides that a limited liability company may not make a distribution if after the distribution: (1) the company would not be able to pay its debts as they become due in the ordinary course of the limited liability company’s activities; or (2) the company’s total assets would be less than the sum of its total liabilities plus the amount that would be needed, if the company were to be dissolved, wound up, and terminated at the time of the distribution, to satisfy the preferential rights upon dissolution, winding up, and termination of members whose preferential rights are superior to those of persons receiving the distribution.

A member of a member-managed limited liability company or manager of a manager-managed limited liability company who consents to an improper distribution is personally liable to the company for the amount of the distribution which is improper distributions. In addition, a person who receives a distribution knowing that it is in violation of the Act is typically personally liable for the portion of the distribution that is improper.

Is Limited Liability an Illusion?

Although it may seem that the exceptions swallow the rule, the LLC offers excellent protection from many types of liabilities. For example if you properly hire and train an employee who then commits an act of negligence or fraud, the LLC should shield you from personal liability. If you sell a product that, without your knowledge or fault, is defective, you should not have personal liability. Trade creditors who deal with the LLC without a personal guarantee should have no right to look to you for payment.

Shoring up Limited Liability

There are several things that you can do to strengthen the protection of limited liability within the LLC:

Business insurance. Carrying adequate business insurance won’t change the fact that you are personally liable for your own negligence, but it can help by providing a source for payment. You might also consider a personal umbrella policy.

Avoid personal guarantees. Not all personal guarantees can be avoided but do not automatically consent to every guarantee. In many cases, landlords or vendors routinely request personal guarantees even where the facts do not dictate that one be provided. Learn to question the request.

Capitalize the business adequately. Provide adequate capital for the entity’s intended purposes and document the capital infusion.

Keep the LLC separate from your personal business. No matter how small the business is, it should have its own bank account. Don’t pay personal expenses from the business account. Instead, write yourself a check (called a draw) on the LLC account and deposit it in your account from which you pay expenses. Likewise, don’t use personal checks to pay LLC bills. If the LLC needs funds, make a capital contribution or loan. And account for everything.

Act ethically. Don’t attempt to mislead the LLC’s creditors about the financial condition of the business.

Do not divert assets. If the business looks like it is going down, don’t attempt to lessen your own loss by taking big draws or moving assets out of the LLC. That will only help open the floodgates to your personal assets.

If you act responsibly and take a few precautions, the limited liability of the LLC is still a major benefit over a sole proprietorship or general partnership.