Can I Set Up An LLC To Avoid Personal Liability In A Lawsuit?
Among the many creative “legal” ideas floating around on the internet is:
If you set up an LLC for yourself and conduct all your business through it, the LLC will be liable in a lawsuit but you won’t.
Last week, I was asked if this “asset protection strategy” worked.
No, it doesn’t.
Conducting your personal business through an LLC provides no protection against a tort verdict, the type of liability that most people are worried about. The use of corporate forms — like LLCs, S-Corporations, or Incorporation — has many important purposes, but avoiding personal tort liability for your own conduct is not one of them.
To see why, let’s start with some background.
What’s a “tort?”
“Tort” is the Norman word for “wrong.” There are three main types of legal wrongs: criminal wrongs, contractual wrongs, and tort wrongs.
A ”criminal“ wrong is an offense against the state: we as a society made it illegal to smoke pot, you did it anyway, here’s your punishment. A ”contractual” wrong is a failure to do something you agreed to do: I gave you $20 to mow my lawn, you didn’t do it, I want my money back.
Everything else is a “tort” wrong. The most common tort is “negligence,” which includes most lawsuits, like car accidents, medical malpractice, or slip and fall. In negligence, you had a general duty to do something in a reasonable way (like drive your car safely) and you messed up, so you have to pay for the harm you caused. Another type of “tort” is an intentional tort, like defamation or tortious interference with business relations: you purposefully hurt me, so you should pay for the damage.
When most people say they’re worried about “getting sued,” they’re usually talking about being responsible a large tort verdict arising from a catastrophic injury or wrongful death.
What’s an LLC?
A limited liability company is a type of business association recognized by state and federal governments as a legal entity independent of its owners and employees. On behalf of the owners, the company can, for example, own property and enter into contracts.
For our purposes here, we do not need to go into the differences between a limited liability company, an S-corporation, full incorporation, or a limited partnership. (I exclude general partnership and sole proprietorship because neither claims to limit liability at all.) All of them serve the same basic purpose, which is to protect investors from incurring any liability greater than the amount they invested into the company. The Economist described the purpose of limited liability a couple years ago:
Before limited liability, shareholders risked going bust, even into a debtors’ prison maybe, if their company did. Few would buy shares in a firm unless they knew its managers well and could monitor their activities, especially their borrowing, closely. Now, quite passive investors could afford to risk capital—but only what they chose—with entrepreneurs. This unlocked vast sums previously put in safe investments; it also freed new companies from the burden of fixed-interest debt. The way was open to finance the mounting capital needs of the new railways and factories that were to transform the world.
How does tort liability work in the context of an LLC?
Most everyone knows, although not by name, “vicarious liability” and “the doctrine of respondeat superior.” If, in the course and scope of your employment, you cause someone else harm, then your employer is liable for your conduct.
Here’s what you probably don’t know:
An agent is subject to liability to a third party harmed by the agent’s tortious conduct. Unless an applicable statute provides otherwise, an actor remains subject to liability although the actor acts as an agent or an employee, with actual or apparent authority, or within the scope of employment.
Restatement of the Law, Third, Agency § 7.01 (emphasis added).
(An aside about The Restatement: The Restatement is an intense effort of lawyers, professors and judges organized by the American Law Institute to reduce to writing the legal community’s consensus regarding general principles of law applied across the country. “Agency” is the subject of this particular Restatement, and “Third” means it’s the third version, which was published in 2006. For reference of how intense these efforts are, the Second version was published in 1958. In case you’re wondering, the Second version also said “[a]n agent who does an act otherwise a tort is not relieved from liability by the fact that he acted at the command of the principal or on account of the principal …”)
An “agent” is a broader definition of “employee:” it’s anyone acting on behalf of the company.
Let me reiterate what that all means: the general legal rule across the country is that individuals acting on behalf of a company are personally liable for their tortious conduct, even if they did so on behalf of the company.
Don’t believe this “Restatement?” Want some case law? Here’s a case from the Virgin Islands less than a month ago, noting in passing the cases it found with minimal research:
Terr. of the U.S.V.I. v. Goldman, Sachs & Co., 937 A.2d 760, 794 n.153 (Del. Ch. 2007) (‘Officers and directors may be held individually liable for personal participation in tortious acts even though performed solely for the benefit of the corporation[.]‘) (quotation omitted); Armed Forces Ins. Exch. v. Harrison, 2003 UT 14, 70 P.3d 35, 41 (Utah 2003); Miller v. Keyser, 90 S.W.3d 712, 717 (Tex. 2002); Saltiel v. GSI Consultants, Inc., 170 N.J. 297, 788 A.2d 268, 273 (N.J. 2002); Haupt v. Miller, 514 N.W.2d 905, 909 (Iowa 1994); Camacho v. 1440 Rhode Island Ave. Corp., 620 A.2d 242, 246-47 (D.C. 1993); Weir v. McGill, 203 Ga. App. 431, 417 S.E.2d 57, 59 (Ga. 1992); Hecker v. Ravenna Bank, 237 Neb. 810, 468 N.W.2d 88, 95 (Neb. 1991); Ingram v. Machel & Jr. Auto Repair, Inc., 148 A.D.2d 324, 325, 538 N.Y.S.2d 539 (N.Y. App. Div. 1989); Mississippi Printing Co. v. Maris, West & Baker, Inc., 492 So. 2d 977, 978 (Miss. 1986); Wyatt v. Union Mortg. Co., 24 Cal. 3d 773, 157 Cal. Rptr. 392, 598 P.2d 45, 52 (Cal. 1979); Jabczenski v. Southern Pac. Memorial Hosp., 119 Ariz. 15, 579 P.2d 53, 57 (Ariz. Ct. App. 1978); Taylor v. Alston, 79 N.M. 643, 447 P.2d 523, 525 (N.M. Ct. App. 1968); New Eng. Box Co. v. Gilbert, 100 N.H. 257, 123 A.2d 833, 835 (N.H. 1956).”
Addie v. Kjaer, 2009 U.S. Dist. LEXIS 36110, at *21–12 (D.V.I. Apr. 28, 2009)(noting, “The Court has come across no jurisdiction that applies a contrary rule.”).
Insurance and employee indemnification are so common today that this distinction is not often appreciated, but it’s still the law. If Warren Buffet defrauded Mom and Pop’s Ice Cream Stand wholly for the benefit of Berkshire Hathaway, he would personally be on the hook for the damage just the same as Berkshire.
Let’s go back to your personal LLC. Assume you hit a pedestrian with a car, defame someone in a blog post, or cause a building fire. It doesn’t matter if you were “employed” by your LLC when you did it — you will still be personally liable, as will the LLC that ”employed” you.
Thus, in order to “protect your assets,” you need to put enough money into the LLC that it can completely pay any tort judgment against you, or else the injured person can go for your assets long after it has bankrupted the LLC. That just defeats the nominal purpose of the LLC (to avoid liability), since you’ll have to pay the same amount anyway, just through the LLC.
Again, there are plenty of reasons for setting up an LLC, such as protecting investors, limiting contractual liability, limiting liability arising from employee’s conduct, and a host of business and tax uses, but avoiding personal liability for your own conduct isn’t one of them.
There’s an easier and more effective way. Buy good personal liability insurance and buy an umbrella liability insurance policy. If you’re running a business, buy a good business insurance policy (including liability) and an umbrella policy for it, too. If your business is unusual, or you’re worried about a particular risk, look for risk-specific insurance, like media policies which cover defamation. Don’t skimp — get at least $1 million in coverage, or more depending on your own risks.
Then you’ll be covered for most tort verdicts (keep in mind some states prohibit insuring intentional conduct, and insurance policies can carve out whatever exceptions / exemptions they want).
No trickery needed, just some money and foresight.