Starting with this post, Verhagen|Bennett attorney Dallas Verhagen will be posting a series of "Know the Basics" blog posts regarding general business and business law topics that are important for entrepreneurs to have a general understanding of.
Should I form an LLC, partnership or corporation for my prospective business, or is it safe to remain a sole proprietor? Is obtaining liability insurance alone enough protection? If I form an LLC or corporation, can I still somehow be held liable for something? Can I make my entity “watertight?” Will an LLC provide asset protection for me? What should I do to limit my contractual liability? If I decide to form an LLC or corporation, are there costs or downsides?
These are questions clients often ask when seeking our help with business formation. It is too often that entrepreneurs are so eager to get started that they forego due diligence and take the quickest, easiest, or least expensive route in terms of business formation.
Sources of Liability:
Business owners typically run into two sources of liability. First, there is contractual liability, which arises when you or your business enter into a contract with another party (e.g. your office lease, financing agreements, vendor agreements, employment agreements, etc). With contractual liability, only the parties to the contract will be held liable absent special circumstances. One example would your office/commercial lease: if your business is the party to the contract and rent goes unpaid, then the business is liable for that unpaid rent (and probably other damages) based on the lease. You, however, are not personally liable for the contractual duties of the business unless you guaranteed the contract or signed it in your individual capacity.
Second, there is tort liability, which is liability arising from the acts of someone. For instance, if you are the member of an LLC that owns a rental property and you personally handle the management of the property, then you may be held liable if you are negligent in making repairs that cause harm to a tenant of the LLC (or someone else who may be injured on your property). It does not matter that the contract between your LLC and the tenant provides for, since it’s your personal act that causes the harm, making you liable. This seems to be a source of confusion for people who erroneously believe that a limited liability entity protects them from their own acts.
Entrepreneurs launching new businesses must think some about the types of contracts and transactions their businesses will likely enter into and think about the potential liabilities that may arise in the context of their specific business. This will help focus in on the relevant points and help determine whether a limited liability entity is needed.
In Terms of Limiting Liability, Should You Set Up an LLC or Corporation, or is Purchasing Liability Insurance Sufficient?
Most other lawyers that I have encountered seem to recommend a limited liability entity for any business venture. On the contrary, insurance professionals and CPAs seem to believe that obtaining insurance is sufficient. So, who is right? Well, the answer depends on the specifics of the business involved, and sometimes there is just no definitive answer.
Let’s consider a few common examples in which liability insurance may be sufficient to protect a business owner. One instance might be a sole proprietor that makes a small real estate rental investment. Let’s assume that this person will have no employees and will manage the property herself. In this instance, with respect to contract liability, the person will have personal liability as landlord under the lease, but the lease agreement itself can define and limit the landlord’s responsibilities and obligations. In the case of any debt incurred to acquire the real estate (or personal property in other cases), most lenders in small real estate deals will likely require a personal guaranty if a limited liability entity is used. Thus, in this context, a limited liability entity probably adds very little in terms of protection from contract liability.
So the real issue here is tort liability. Will a limited liability entity protect the person from tort liability? While it’s impossible to give a definitive answer to this question because of the variety of situations that can cause tort liability, it’s likely that there will be little protection added by a limited liability entity in this specific example. Under most (maybe all) statutes providing for limited liability, an individual is liable for his or her own actions, including negligent acts. Here, the sol proprietor has no partners or employees, and thus it’s likely that any negligence will arise out of the her own conduct (e.g. broken stairs that the landlord does not repair and which causes a tenant to fall and harm herself). Therefore, it’s unlikely that a limited liability entity would add much protection, if any. I’m not saying that it adds no protection at all, as I believe there is always some minimal level of protection provided when a lawsuit is filed and there is an entity in place. But in this case, the protection may not amount to much.
A second example might be a consultant, with no employees or partners, who merely provides consulting services. A similar analysis applies. Since the consultant's contract can define and limit the contractual liability and almost all tort liability would result from the consultant’s personal negligence, a limited liability entity would provide little benefit.
On the contrary, let’s suppose the facts are such that a person is buying a large, multi-story building with four other people, or perhaps starting a business with fifteen employees. In either case, there is much more risk to protect against, as the person has multiple partners or employees whose actions may cause her to incur potential liability. In this case, a limited liability entity would make more sense.
But doesn’t insurance protect against all of these risks? Many people seem to forget the very basic nature of an insurance contract, which is that it is indeed just a contract between two parties: the insurer and the insured. As with any contract, it only covers what is delineated in the contract and it excludes what the language of the contract says it excludes. “Having insurance” does not amount to equal protection from anything and everything. So my advice here is to consult with a knowledgeable insurance pro and to have your policy and endorsements reviewed by legal counsel.
Lastly, the costs of creating and maintaining the entity and the associated taxes incurred as a result of the entity must be considered. In general, implementing and maintaining an entity isn’t very expensive; but there are up-front costs, annual registration fees, and possibly additional state taxes. For example, a California LLC costs $70 to form (plus legal fees) and an $800 annual minimum franchise tax, plus a fee (if the annual California income is over $250,000). In addition, having a limited liability entity may subject the earnings and assets of the business to taxes. For example, California C corporations do not allow for pass-through taxation, meaning both the company and the owners pay taxes. Additionally, the county that a business is located in will typically require a business license to operate, which can be a few hundred dollars depending on the area.
In sum, the decision of whether or not to form a limited liability entity requires a thoughtful cost-benefit analysis. As a rule of thumb, if you are starting a business and do not plan to have partners or employees, then I recommend taking a hard look at what protection (if any) a limited liability entity might provide. On the contrary, if you do plan to have partners or employees, then I would generally suggest having an entity. Of course, the decision comes down to more than whether you'll have partners or employees (e.g. tax consequences, likelihood of outside investors, etc.), but this is a great place to start.
About the Author:
Dallas Verhagen is a business attorney and a partner of
Verhagen | Bennett LLP. To learn more about Dallas, please click here.
For questions or comments about this post, please email Dallas directly at: Dallas@VerhagenBennett.com
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© 2017 Dallas P. Verhagen — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.