Starting a business involves a certain amount of inherent risk. There are no guarantees that the founders of a company will get along, a product or service will sell, or market conditions or competitors will not create unforeseen problems.
While entrepreneurs must be willing to take a leap of faith, there are steps they can take to reduce risk, both to the business and to themselves. When forming a business, entrepreneurs can choose a legal structure with limited liability. By legally separating the business from themselves, owners can at least know that if the company faces financial distress, their individual assets will not be at risk.
However, limited liability is not limitless. There are several ways that business owners can be personally liabile even when their company provides a liability shield.
The Meaning and Purpose of Limited Liability
Limited liability means that business owners and investors can lose only the money they invest in a company. They are not personally liable if their company faces creditors’ claims due to a lawsuit or debt. Creditors can come after the economic assets an individual has invested in a business but not the individual’s private assets.
To illustrate the importance of limited liability, imagine if every business owner’s personal assets were at risk if their business became insolvent. Undertaking a new venture would involve too much risk for many individuals, and most businesses would never get off the ground.
Three common types of modern business structures provide limited liability:
- limited liability company (LLC)
- limited liability partnership (LLP)
- corporation
It is taken for granted today that owners of these types of businesses are not responsible for the debts and actions of the business entity. But the LLC has only been around since 1977. And corporate limited liability as we know it only dates back to around 1800. Indeed, modern capitalism is unimaginable without limited liability.
Limited Liability Origins
An early predecessor of the limited liability structure was the joint-stock company, which has its roots in European exploration of the Americas.
Trips to the New World were expensive and dangerous. Entrepreneurs of the day came up with a new business plan. They sold stock in companies that were engaged in voyages to the New World to wealthy individuals, who provided capital in exchange for a portion of the profits but were not responsible for the companies’ actions.
The settling of the American colonies is closely tied to English joint-stock companies of the 1600s. Today, joint-stock companies no longer exist. But the legacy of these early limited liability companies lives on in corporations, LLCs, and LLPs.
The Limits of Limited Liability
Bifurcation of business and personal assets—the cornerstone of limited liability legal structures—is not absolute. Although courts are generally hesitant to impose personal liability on a company’s owners, they may do so in some situations, such as the following:
- The limited liability business entity was not properly formed (e.g., because the appropriate paperwork was not filed with the state, and thus the separate legal entity was not formed).
- A business owner’s or their employee’s negligent or reckless actions cause injury to another person (i.e., the tort exception to limited liability).
- The owner personally guarantees a business loan on which the company defaults.
- A state or federal statute imposes liability on the owners (e.g., laws related to environmental and tax liability).
- The “veil” is “pierced” because an owner did not maintain the separation between their personal affairs and business affairs, for example, because they commingled personal and business funds.
The term “piercing the veil” applies not only to corporations but also to LLCs and LLPs. In a general partnership, only the limited partner has limited liability.
Typically, courts will not pierce the veil simply because a creditor will not otherwise get paid. Veil piercing requires evidence that the company was somehow used to perpetuate fraud or abuse the limited liability structure. For example, the court may decide that veil piercing is appropriate in the following scenarios:
- A company was knowingly formed with insufficient capital to meet its contractual obligations and normal business functions (undercapitalization).
- The business entity is a mere instrument for transacting the personal affairs of the owners/shareholders/members/partners and serves no legitimate purpose.
- There is evidence of fraudulent activities, such as an owner who siphons business funds.
- A company failed to follow compliance requirements, such as filing an annual report, holding annual meetings, obtaining business licenses, and having a registered agent.
Courts use a multifactor test when determining whether to pierce the veil, and different states’ courts vary as to the factors they consider in their analyses.
How to Maintain Limited Liability
Keeping the limited liability of a corporation, LLC, or LLP intact requires knowing and preventing the circumstances that can eliminate the liability shield. Specifically, owners should understand the following and take the following steps to maintain limited liability:
- File the appropriate paperwork with the state at the time of business formation.
- Torts committed in the business can expose them to personal liability. This can include actions carried out by employees.
- Owners can be held responsible for business debts they personally guarantee.
- Some laws, such as the federal Superfund law, impose owner liability (owners should also be aware of available defenses, such as acts of God or war in the case of Superfund liability).
- Respect business formalities that make veil piercing less likely. Always hold board and shareholder meetings, pay dividends, and maintain detailed books and records, and avoid commingling personal and company funds to maintain the separateness of the limited liability entity.
Get Help from Our Attorneys
The limited liability of corporations, LLCs, and LLPs is only disregarded in extreme cases. In addition, good business practices will help you avoid situations such as debts and lawsuits that can lead to challenges to the limited liability provided by your business entity.
Of course, business risks cannot be eliminated altogether. If you need help developing liability safeguards or defending your limited liability in a legal action, please contact our office to schedule a consultation.
