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Both corporations and limited liability companies (LLCs) are “limited liability entities.” Sole proprietorships and partnerships are not. The primary advantage to forming a limited liability entity is obtaining limited personal liability for the owners of a business (the shareholders, if a corporation, or the members, if an LLC). When a shareholder or member invests money in a limited liability entity, his or her liability for the debts of the corporation is generally limited to what he or she has invested. For example, if an investor invests money in a publicly traded company that is liquidated in bankruptcy proceedings, a creditor of the defunct business is generally prohibited from pursuing its claim against John Doe, who happened to purchase 1,000 shares in the defunct company through his online trading account in the hope that the company could manage a turn-around.
However, most limited liability entities are not merely instances of individuals passively investing in a corporation or LLC. While publicly traded companies may have passive investors, most businesses are owned and operated by self-employed entrepreneurs. Thus, the vast majority of businesses in this country are “closely-held” by their investors, insofar as most business owners also provide management (most typically as a director, president, vice-president, secretary, treasurer, member, or manager of the business) or other personal services to the company. For most businesses, limited liability protection and risks must be analyzed in accordance with this larger dynamic of “closely held” business entities.
In this larger dynamic, the personal asset protection to the business owner afforded by forming a corporation or limited liability entity has two components: contract limited liability and tort liability.
Because limited liability entities are treated as legal persons separate from their owners, the liability for contractual debts and claims against a limited liability entity is generally limited to the business itself and its assets, unless such obligation was otherwise personally guaranteed by one or more of the owners. To take proper advantage of this contractual limited liability protection, parties entering into contracts on behalf of a corporation or limited liability company must be careful to execute every contract properly. The contract should include the: (1) full and complete official name of the corporation (including its limited liability designation “Corporation,” “Inc.,” “Corp.,” etc.) or limited liability company (typically “LLC”); (2) signature of the party authorized to sign the contract on behalf of the corporation, and (3) title or other designation of authority of the party signing on behalf of the business. Including these three elements helps to ensure that it is the separate entity that is the signatory to the contract, and therefore responsible for the obligations and promises within the contract, and not that of the individual signing the contract. Contracts are therefore frequently signed as follows:
CORPORATION NAME, INC.
By: John Doe
LIMITED LIABILITY COMPANY NAME, LLC
By: John Doe
Its: Member (or Manager)
A “tort” is a legal term that indicates a “cause of action” (a reason to bring suit against someone) based on his, her, or its act of negligence or omission. An act of negligence is doing something that one ought not to have done (e.g. driving too fast for weather conditions), whereas an omission is failing to do something one ought to have done (e.g. not cleaning-up a known and obvious danger). While there are many limited liability protections afforded to business owners who incorporate or form an LLC, what most entrepreneurs do not know, and often are not told, is that by providing personal services to their business they subject themselves to at least some degree of potential liability insofar as each business owner (like all natural persons) is always and inescapably liable for the acts of negligence or omissions that he or she personally commits. If this was not the case, forming a corporation or an LLC would be tantamount to having a “license to kill” – one could act recklessly or negligently, injure or possibly kill someone, and without legal consequence. Thus, courts long ago decided that it was in society’s best interest that every individual remain personally liability for his or her own acts of negligence and omissions.
Rather, tort limited liability protection exists for the business owner when the act of negligence or omission is committed by an employee or agent of the corporation. The employee or agent will have personal liability for their actions. To the extent that the employee or agent was acting within the scope of his or her employment, the corporation will also be held “vicariously liable” for the actions of its employees and agents. But the individual shareholders of the corporation will not be liable.
Exceptions to tort limited liability protection include such instances where a director, officer, member, or manager is himself or herself implicated in the employee or agent’s act of negligence, for example in having been found to have negligently supervised or hired the employee or agent, or wrongfully failed to fire the employee or agent.
An important exception to limited liability protection in a closely-held entity is found when a court of law orders the “veil” of limited liability protection to be “pierced.” When the veil of limited liability protection is pierced the limited liability protection of the entity may be ignored for the purposes of bringing claims against the shareholders, in a corporation, or against the members, in an LLC. A limited liability entity’s veil may be pierced in extreme situations if it is determined that the business is merely a “shell” (a corporation or limited liability company in name only, rather than in form, for example, in failing to perform any necessary corporate formalities, such as holding annual shareholder meetings, etc.), the “alter ego” of the participating shareholder or member, is grossly under-capitalized in light of its activities, or, in some instances, is recklessly under-insured.
Generally, courts look at the following factors in determining whether or not to pierce a veil of limited liability protection.
One way to avoid the negative consequences of failing to perform certain formalities is to operate as a statutory close corporation or LLC because of the fewer formalities, if any, associated with such entities. Both the statutory close corporation supplement to the South Carolina Business Corporations Act and the South Carolina Limited Liability Company Act state that failure to perform any corporate or company formally shall not be the basis for imposing personal liability on the shareholders or members. Professional corporations can also elect to be statutory close corporations. Standard corporations can quite easily be converted to statutory close corporations. And both professional corporations and standard corporations can convert to being an LLC.
Closely-held limited liability entities should also be careful to ensure against co-mingling entity cash and other assets with those of the owners. Corporate or company checks should never be written to directly pay for personal items of the shareholders or members. Similarly, if assets, such as equipment originally purchased by an individual, are to be used by the company, such assets should be formally assigned or transferred to the company by written resolution or assignment, or otherwise evidenced by a written bill of sale to the company from the individual.
Individuals who have a controlling interest in a limited liability entity should also never intentionally use the limited liability protection of a corporation or limited liability company to defraud creditors; such as unreasonably committing to pay $5,000.00 dollars on contract when the company has never had more than $500.00 dollars in its company bank account and has not arranged for other reasonably means of financing such debt; or performing demolition work, but having insurance in an amount that it should know was unreasonably low. Limited liability protection is generally upheld by federal and state courts, but the controlling parties who rely on such protection must be acting fairly and in good faith.
Limited liability protection, therefore, should not be thought of as unlimited liability protection. Use of insurance and good faith practices are not rendered obsolete simply by incorporating or forming an LLC. As with most business matters, individuals contemplating whether to operate as a limited liability entity or not might simply wish to do a cost benefit analysis in making such a decision. Is the cost of forming a limited liability entity (usually a few to several hundred dollars) worth the limited liability protection with regard to employee and agent torts and contract obligations that one obtains, assuming one acts in good faith with regard to business dealings. Judging by the numbers of corporations and LLCS operating, it would seem that most people conclude in the affirmative.
Personal asset limited liability protection is only one reason among many that one should consider when contemplating whether or not to operate one’s business as a limited liability entity. The greater legitimacy afforded to corporations and LLCs by potential customers and clients due to the belief that having certain documents filed with government offices makes it more likely they are dealing with a reputable company, may be worth the price of admission alone. Still other important benefits of operating as a corporation or LLC include the avoidance of the joint and several liability they would have as a general partnership, as well as to benefit from business asset protection. For, under certain circumstances, operating as a LLC or as multiple entities, such as holding and operating companies, may help to protect one’s ownership interest in a company and the underlying assets of a company for causes of action against business owners that may or may not have anything to do with one’s business activities. Depending on the circumstances, certain tax advantages can also apply.
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