Why Form an LLC or Incorporate? – Understanding & Protecting the Limited Liability Shield

A corporation or Limited Liability Company (LLC) is a huge personal liability shield against the world. This is, perhaps, the main reason for a business owner to form a corporation (i.e. “incorporate”) or an LLC. Today’s post aims to describe what limited liability protection is about, why you may want it for your business, and some things to keep in mind to stay protected.

A brief history of the Corporation

The protection offered by a limited liability entity, such as a corporation or LLC, arises from the legal personality of the entity. The law recognizes these entities as “persons” separate from their owners. Just as one person generally cannot be held responsible for the actions of another, so too are owners of a corporation or LLC generally not responsible for what could be considered the entity’s “actions.” The concept of legal personality can be traced far back to ancient Rome.

The modern corporation is an evolution of the English chartered company, the oldest of which included the universities, the church and the inns of court. Except for these ancient associations which were recognized as having received their charters from “time immemorial,” chartered companies required the grant of a charter by the Crown, a privilege that was exceedingly rare and often carried with it certain monopoly rights. It is from these “charters” that corporate formation documents such as the “Certificate of Incorporation” are fondly referred to as “charter documents.”

While the corporate form has its roots in antiquity, its widespread use is a 19th Century American innovation grounded on American ideals of democracy.

What is the Limited Liability Shield?

The limited liability shield protects the personal assets of the owners, directors, officers, managers and agents of a corporation, LLC or similar entity. It is literally a shield against the world that does not break except in limited circumstances.

Courts recognize that liability protection is the main motivator for forming an LLC or incorporating, and have expounded on the nature of such an entity as a shield. In the 1924 case Elenkreig v. Siebrecht the New York court of appeals stated the following:

When you enter into a deal in the name of your LLC or corporation, you are putting up that big shield that defends you from losing your personal assets should the deal go awry. So long as the shield is remains intact, only the assets of the LLC or corporation, such as the company bank account or company property is at risk of loss.

Why do I need the Limited Liability Shield?

Doing business can be fraught with uncertainty. A passerby could slip in front of your store. A sudden world shortage could hinder the performance of a contract. Your partner or employee may screw up. The United States is a country of lawsuits, and there are countless scenarios in which a business can be sued.

Without the Limited Liability shield, a business owner’s own assets are fair game in a lawsuit. Life savings, personal comforts, and stuff set aside for family, could all be gone in an instant, even if the business owner was not at fault.

Without the Limited Liability shield, the only bulwark against losing everything is purchasing insurance. However, insurance companies are not your friend. They want to pay as little as possible and want you to pay as much as possible. They have their own interest at heart, not yours.

How can the Limited Liability Shield be Broken?

The Limited Liability shield is not absolute. A person can choose not to be shielded. In certain circumstances, the shield can splinter and break. As previously mentioned in the history section of this post, limited liability is grounded on the principle that a corporation or LLC is its own separate person. All attacks on the Limited Liability shield can thus be broadly categorized as attacks on a corporation or LLC’s legal personality. This is generally termed “Piercing the Corporate Veil.”

Owners of a corporation or LLC can be held responsible for the entity’s actions on the same limited grounds that a person can be held responsible for another person’s actions. The most obvious case of this is a “personal guarantee” where an ordinarily protected person such as an owner, shareholder, director, officer or manager, agrees to be personally responsible.

Likewise, protected persons are not protected from their personal wrongdoings. When Lex Luthor punches Superman, his ownership of LexCorp won’t save him. Specific laws and legal principles have been crafted by courts and lawmakers, or have arisen out of custom, that make protected persons not protected. Thus, professional malpractice, such as when a doctor prescribes the wrong medicine, is considered a personal wrong. Specific laws, such as those to do with employee wages or the issuance of non-exempt unregistered securities, can create personal liability. Extremely bad behavior (such as fraud) could also be considered a personal wrong.

The “Corporate Veil” can also be pierced under legal principles designed to bypass or negate an entity’s separate personality.

Bypassing of a corporation or LLC’s separate personality may occur under principles of agency law. For example, under agency law, a principal can be held liable for the acts of his or her agents performed within the scope of the agency. The simplest example of a principal-agent relationship is that of employer-employee. Under corporate law principles, corporate officers are generally considered agents of a corporation, and are thus able to perform acts on behalf of the corporation (such as signing a contract). However, if a corporate officer exerts such “dominance and control” over the corporation that the principal has become the agent and the agent has become the principal, a court may conclude that the officer (essentially the principal) can be held liable.

Negation of a corporation or LLC’s separate personality may occur when company assets are not kept separately from its owners’ or when necessary formalities fail to be adhered to. In the first case, negation occurs because it looks like the company and its owners are the same person (like the Green Arrow and Oliver Queen are the same person). This is often aptly called the “Alter-Ego” theory. In the second case, negation occurs because it looks like the company does not actually exist (humans need water, and corporations need board meetings).

How do I protect the Limited Liability Shield?

Since the Limited Liability Shield is grounded on the separate legal personality of a corporation or LLC, the more separate and distinct the corporation or LLC is kept from its owners, officers, directors and managers, the better. This includes the following:

• Announcing the separate legal personality status to the world: e.g. having the company name on all stationary, and signing “Mr. X, President, on behalf of School of Gifted Youngsters LLC” in contracts
• Actually staying separate: e.g., keeping separate bank and other accounts, and not using company property for personal benefit
• Sticking to the chain of command: i.e. ensuring that relevant actions taken by officers and agents have been authorized by the Board of Directors (considered representatives of a corporation)
• Don’t let the company’s blood run cold (money): i.e., ensure the company has enough capital to conduct its business
• Feed the company its daily bread (necessary formalities): e.g., holding annual meetings, making necessary filings, issuing equity, keeping proper records, and adhering to and updating bylaws and other internal governance and management policies
• Having the papers to back it up: i.e., document everything related to the above to ensure that the evidence is there if it needs to be used
• Read the fine print: no amount of liability protection can help you if you sign it away, so make sure that you’re not unknowingly signing a personal guarantee
• Don’t be a super-villian: Remember, you can be liable for anything that the law considers “personal” actions.

We hope this post has been helpful to you, and that your Limited Liability Shield remains brilliant and unpierceable. Happy new year! May your 2016 be abundant with success!

This blog post is provided for general informational purposes only. It is not legal advice, and should not be a substitute for legal advice. If you have questions or comments about the post, or would like to learn more about something in the post, please feel free to contact me.