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.

 

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  • http://www.litigationandtrial.com Max Kennerly

    Several readers have asked, “why $1 million?”
    The number isn’t plucked out of thin air — it’s roughly the amount of coverage a number of states (like Pennsylvania, which is $1.2 million) require physicians carry for medical malpractice claims.
    It is thus generally sufficient to settle most catastrophic injury / wrongful death claims, and usually enough to get a plaintiff’s attorney to recommend settlement to their client instead of personally executing against the tortfeasor, regardless of tortfeasor assets.
    Most claims are resolved for far below $1 million; yet, if the issue is asset protection and worst-case scenario planning, then there’s no good reason to skimp.

  • http://followmybusiness.blogspot.com Chris

    Great article. Just to add to it. If you do have an LLC, especially a single member LLC and purchase a Business Package Policy, or outright GL policies, make sure that either, your membership agreement will have the LLC idemnify you for actions done in the course of business.
    The $1M number also comes from several things. GL policies normally provide $1M occurance/$2M aggregate. Second, if you contract with any larger company, they normally require you to evidence at least $1M in coverage.
    Remember General Liability/Public Liability protects you for liability due to bodily injury or property damage. GL policies specifically exclude auto liability unless you buy an endorsement so make sure you have auto coverage. Also make sure your insurer knows you use it for buisiness or they can deny the claim.
    Finally, if you are doing professional consulting, check with your local professional society to see if they have professional liability coverage to protect you from liability due to financial loss. You might be surprised what you can find. Also, if you are a programmer, see if the company you are working with has a program set up for small entities and independent contractors since tech E&O can be expensive.
    Wish I could write more, I have done all of this for large fortune 500 companies.

  • http://www.twincitiesbusinesslitigation.com Gavin Craig

    This is a good reminder for all small business owners. I’ve expanded on your post, in my blog, to address the liability of LLC (corporate) owners when they cause the business to breach a contract.
    Gavin Craig

  • http://www.twincitiesbusinesslitigation.com/2009/05/articles/law-1/when-a-corporation-or-llc-does-not-protect-the-owner-shareholder-from-personal-liability/index.html Twin Cities Business Litigation Blog

    When a Corporation or LLC Does Not Protect the Owner (Shareholder) From Personal Liability!

    Finding the corporation (LLC) business owner personally liable for their actions. In the right circumstances, there may be a way.

  • William Mitchell

    Would an anonymized Wyoming LLC make it more expensive for a plaintiff to go after you? You would have no liability shield, but they would have to go to court just to find you, would they not?

  • James Egan

    I have a question (this may have been explained above but I am not proficient in legalese).
    If I own an LLC company and one of my employees commits a tort (say my employee runs over a guy and he is in the hospital), can the victim come after my personal assets? or am I only liable up to my investment in the company?

  • A. Lester Buck III

    I am not a lawyer, but I have attended several real estate investor meetings. There appears to be a cottage industry of “asset protection” lawyers that come by and teach LLC strategies. If I remember correctly, they claim that a properly structured LLC cannot be forced to make a distribution unless all members agree, so if one is sued and they win a judgement, they will not receive any payout for a potentially indefinite period. They claim that the IRS will impute the full value of the judgement immediately as taxable income, which makes the entire process unattractive to the plaintiff, and plaintiffs are much more amenable to a settlement rather than going to trail. Is any of this standard pitch correct? Can one really hold off plaintiffs with this threat of a huge tax bill and indefinite future payout?

  • John Farrem

    This looks like the usual FUD to get people to spend money on unnecessary expenses such as liability insurance.
    If LLC has no value, why was it created in the first place?
    Why state the obvious (no one has protection against own criminal conduct – not even a CEO of a Microsoft or Google)?
    This article looks to me like typical scare tactics of a smooth salesman.

  • Max Kennerly

    John – I think you missed the point of my post. The LLC has plenty of value. It can, for example, protect you from personal liability for your employee’s conduct. What it can’t do — and what was the point of my post — is protect you from personal liability for your own conduct.

  • http://www.facebook.com/people/Maurice-Brown/668529154 Maurice Brown

    This should be required reading for anyone starting an LLC.