The overriding benefit to doing business through an entity is limited liability. But there are numerous gaps in liability protection that may not be obvious. This article describes those gaps and how they may affect you.
Limited Protection for Owner’s Professional Malpractice. For entities providing professional services, there is generally no protection to an owner for his own negligence or that of others whom he supervises or controls. In Oregon, whether a shareholder of a professional corporation, a member of an LLC (see ORS 63.074) or a partner of an LLP (see ORS 67.105(4)), an owner is not only liable for his own malpractice in performing professional services (and that of persons he supervises or controls), but is also vicariously liable for the malpractice of other owners, up to a limit of $300,000 per year. ORS 58.185(3), (4) and (5). Similar rules apply in Washington, except that there is no vicarious liability for malpractice of other owners. See RCW 18.100.070 and RCW 25.15.045.
Limited Protection for Owner’s Negligence. In general, an entity does not protect an owner from liability of injuries he personally causes to others or their property. For example, if an owner is at fault in a vehicle accident while conducting company business, the other party may sue the owner for personal injuries and vehicle damages. Along the same lines, an owner is liable if he injures a customer when demonstrating a product or failing to perform maintenance.
An illustrative case is Morris v. Cee Dee, LLC, 877 A.2d 899 (Connecticut Appellate Court, 2005). An LLC renting mobile homes had only one owner, who personally managed the units. The LLC had no liability insurance. On several occasions a tenant complained to the owner about a sharp and rusty vent sticking out 3/4 inch from the floor. The owner personally visited the unit on two occasions, but did nothing. The tenant then cut his toe on the vent, and ultimately had to have his leg amputated. The tenant sued to attach both the assets of the LLC and those of the owner. The Connecticut court of appeals held that the owner’s personal assets could be attached because he personally visited the unit, knew of the defect and failed to repair it. Had the tenant brought the problem to the attention of the LLC’s maintenance person (other than the owner), and had the maintenance person failed to correct the problem, the owner might have escaped personal liability. An important fact in Morris is that the LLC had no insurance coverage. If an insurance carrier had provided $1M of coverage to the plaintiff, it is likely that the case would settled.
Protection from Contractual Liabilities – If No Personal Guarantee. An entity protects an owner from personal liability on contracts between the entity and third parties, such as an office lease, equipment lease, inventory purchases, credit line, subscriptions, insurance, accounts payable and salaries. There is one huge exception; landlords and bankers almost always insist on personal guarantees.
Protection from Employee Issues. In general, an entity protects an owner from claims for employment discrimination based on age, sex, disabilities, race, etc.
Protection from Tax Liabilities. In general, an entity protects the owner from personal liability for entity-level taxes. Once again, however, there is a huge exception. An owner is usually personally liable for income, employment and sales taxes withheld from employees or customers but not paid over to the tax authorities. Unfortunately, it is relatively common for owners of defunct businesses to end up with huge tax liabilities because they withhold taxes and use the monies to pay other bills. To make matters worse, these types of tax liabilities are not dischargeable in bankruptcy. See, for example, IRC § 6672.
Protection from Environmental Liabilities on Real Estate. In general, an entity protects the owner from personal liability for environmental remediation liabilities associated with contaminated real estate. This is a key reason why savvy businesspeople almost always purchase commercial real estate through an entity.
In summary, it usually preferable to do business through an entity, rather than individually. However, the “limited liability” aspect of using a business entity is far from bulletproof. At a minimum, the owner should purchase insurance to cover business risks.