After insurance, the next most important step an entrepreneur can take to protect against litigation is to set up a business entity. Doing so can protect their personal assets from their business liabilities.
Most businesses start off as either a sole (one owner) or a partnership (several owners). Legally, sole proprietorships and partnerships are treated no differently than the individuals that own them. A judgment against either of these business structures can be collected from any of the business owner’s assets, including their personal assets, like their homes, their savings accounts and their flat screen televisions. In most cases, partners are jointly and severally liable, meaning a judgment against the partnership can be collected solely from the assets of any one partner, leaving them to seek contribution from the other partners.
The better alternative is to set up either a corporation or a limited liability company (LLC). These entities are treated as “persons” separate from the people who own them. Corporations are owned by “shareholders”, LLCs are owned by “members”. For the most part, shareholders and members are insulated from the liabilities of the entity, meaning a judgment won against the entity can only be collected against the assets actually owned by that entity. The individual assets of the shareholders and members are protected from the liabilities of the entity–they get to keep their house if someone slips and falls on business property.
However, there are some important exceptions to the entity liability “umbrella”:
1. Personal Guarantees.
New businesses and established businesses that own very few assets are not the best credit risks. So it’s not unusual for lenders to require the owners to personally guaranty the entity’s obligations. As a result, despite the protection offered by either an LLC or a corporation, many transactions will require the members or shareholders to effectively waive the entity shield, and agree to subject themselves to personal liability for the debts of the business.
2. Professional Malpractice. Professionals who set up their practices as LLCs or corporations will still be personally liable for their own malpractice. Depending on state law and the type of entity, they may also be liable for the malpractice of their partners and their employees. Accordingly, for doctors, lawyers, accountants and other professionals, malpractice insurance is essential regardless of the entity they choose!
3. Wages and Payroll Taxes. Depending upon state law, a corporation or an LLC might not insulate a business owner for unpaid employee wages. New York’s Business Corporation Law specifically holds the ten largest shareholders of a closely held corporation jointly and severally liable for unpaid wages.
Likewise, a shareholder or member who is deemed by the IRS to be a “responsible person” could also be held personally liable for unpaid federal employment withholding taxes. These individuals might also face criminal charges.
4. Veil Piercing. Due to the formalities that must be followed with the corporate structure, veil piercing is more common with corporations than it is with LLCs. In certain instances, a court may look through the “corporate veil” and allow a business creditor to enforce a corporate judgment against the shareholders. While courts are reluctant to “pierce” the corporate veil, they may do so where they determine it is warranted, including cases where:
—Corporate formalities are not followed. Failing to maintain corporate records, (ie. the “black book” is blank), hold shareholder and director meetings, and vote major corporate actions may lead a court to find that the shareholders are not entitled to corporate protection
—Business and corporate funds are commingled. If money is flowing back and forth from the corporation to the shareholder, or if the shareholder is personally paying the corporation’s expenses and vice versa, a court is more likely to find that the corporation is merely the “alter ego” of the shareholder with no true separate existence. Corporate and personal funds should be maintained in separate accounts and expenses should be paid by the party that incurred them.
—The business is undercapitalized. When a corporation is merely a shell, with no funds or assets, and no reasonable means or expectations to pay its debts, a court is more likely to look to the shareholders to pay a judgment creditor.
4. Litigation Costs. While it’s true that shareholders of corporations and members of limited liability companies are not liable for most of the debts and obligations of their businesses, they may still be sued individually. A common tactic for a litigation plaintiff is to sue anyone who might have the ability and desire to pay to settle the case. As mentioned in previous posts to this blog, defending a lawsuit can be expensive. Even a frivolous lawsuit needs to be defended. The liability shield offered by a corporation or an LLC may discourage a plaintiff from suing the owners, but it won’t protect owners from having to defend the lawsuit if they are sued.
These exceptions are fairly narrow and shareholders and members will be protected from the majority of liabilities their businesses will incur. Additionally, the cost to form and maintain corporations and LLCs is nominal in comparison to the protection these entities provide.
While corporations and limited liability companies offer similar protections, there are important differences in the two entities. Accordingly, a business owner should always consult with an attorney in deciding which entity is right for their business. Additionally, they should consult with an accountant, since there can be tax benefits in choosing one entity over another.
And remember–neither entity is a substitute for proper insurance, since a judgement can still be enforced against the assets owned by the business. When the thunder clouds of litigation begin to mass, you can never have too many umbrellas.
Brady Business & Real Estate Advisor 
Posted on 10/20/2010
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