LLC's and Limited Liability Protection: A Primer for the Small Business Owner

KKOS Lawyers is the Entrepreneur’s Law Firm.  By definition, an entrepreneur is someone who assumes the financial risks of a new enterprise and who undertakes to provide its management. The LLC or an s-corporation are typically the preferred business entities of choice for the entrepreneur / small business owner.  This article focuses on the LLC. An LLC typically consists of Owner/Member(s) and a Manager(s), although an LLC could be setup as Member-Managed.  One reason for its popularity is that the LLC provides limited liability for the Member(s) and Manager(s).    Hence, the purpose of this article is to help the small business owner recognize the benefits and the limitations of the limited liability that an LLC provides to the owner(s) and manager(s).  First, the Owner/Member:
LLC Owner/Member Liability

  1. Cash Investment (Capital Contribution). An Owner/Member of an LLC is always at risk to lose their cash investment in the business.  An LLC cannot prevent that.  If the business fails, the Owner(s)/Member(s) lose(s) their cash.  But that is typically the extent of their exposure.
  2. Liability to the Other Owners/Members. Typically, except for criminal acts or gross negligence, an Owner/Member is not personally liable to the other Owner(s)/Member(s) of the LLC.
  3. Liability to Third Parties under Contract Law. Generally, a contract signed by the LLC on behalf of the LLC Manager(s) does not expose an Owner/Member to personal liability.  However, this is only true if the contract does not require a personal guaranty, e.g., in the context of a business loan or other financing.  In such an event, the Owner/Member who personally guarantees the loan will be personally liable for the debt obligation.
  4. Liability to Third Parties under Tort law. An Owner/Member of an LLC is not liable for a tort committed by the Company or under the direction of the LLC Manager, or for a tort committed by the LLC Manager acting outside the scope of the Manager’s authority.  However, an LLC is not a license for an Owner/Member to act criminally or even negligently, especially if the LLC is such that the Owner/Member is also the LLC Manager and/or has direct dealings with third parties on behalf of the LLC, such as if the LLC is Member-Managed.  In such a situation, if the Owner/Member has in fact taken action that results in a tort against a third party, there can be personal liability.
  5. Liability to Third Parties as a Professional. If the Owner(s)/Member(s) of an LLC is/are licensed professionals, such as doctors, lawyers, accountants, etc., an LLC will not protect from malpractice and related negligence.  This is a good example of how insurance is always important regardless of the form of business.

The manager(s) of an LLC is also protected from liability in certain respects, similar to the CEO or Chairman of a corporation.  The policy behind this protection is so a company can recruit the best and brightest individuals to manage and run the day-to-day operations of the company without being exposed to personal liability:
LLC Manager Liability

  1. Liability to the Owners/Members under Fiduciary Law. Typically, the LLC Manager has a fiduciary duty to the Company and therefore serves the interest of the Owners/Members as a whole.  If the LLC Manager breaches that fiduciary duty, there can be liability.  In short, a fiduciary duty means a duty of care and a duty of loyalty.  In the case of duty of loyalty, that means a duty to subordinate self-interest to the interest of the LLC, such that any conflict of interest must be disclosed, although a conflict of interest that has been disclosed can typically be waived in the LLC Operating Agreement.
  2. Liability to Third Parties under Contract Law. A Manager who signs a contract in its role as Manager on behalf of the LLC has no personal liability to the other party(ies) to the contract.  But as mentioned previously, this is only true if the LLC Manager does not personally guarantee the contract, whether the contract is a loan, lease, etc., and only if the LLC Manager is authorized to enter into such a contract on behalf of the LLC.
  3. Liability to Third Parties under Tort Law. Typically, a Manager is indemnified by the LLC for actions the Manager takes that are within the scope of her role as Manager.  This is one of the benefits of having an LLC because it allows a Manager to run the business without fear of personal liability.  But, a Manager may be held personally liable for criminal action and intentional actions that are outside the scope of its authority.

As you can see, LLC liability is not as simple as it is sometimes described.  Also, this article is focused on personal liability of LLC Owners and Managers.  The liability of the Company is another matter, such as when the actions of an employee of the Company result in liability for the Company under the legal principle of Respondeat Superior, which is Latin for, “don’t hire dummies” (it’s actually Latin for, “let the master respond.”)  But fortunately, with an LLC or other business entity type that limits the liability of the owners, only the Company and not the Owner is liable for the negligent actions of the employees.
However, beware that in rare situations, an LLC will be disregarded by a judge in a lawsuit involving the business.  If that happens, all of the benefits of the LLC discussed herein are also disregarded.  This might happen if the LLC is being used to perpetuate a fraud, circumvent the law, or some other illegitimate purpose.  This also might happen if the LLC is setup to be insolvent, i.e., not adequately capitalized, or personal and business interests are commingled to the extent that the LLC has no separate identity.
Also, please note that some of what has been discussed herein can be modified in the LLC Operating Agreement, except where prohibited by law.  Additionally, LLC’s are typically governed under state law, which are not uniform across the Country.
In sum, the LLC provides liability protection but it is not the end-all, be-all and should be used in concert with insurance in all its forms, e.g., liability, errors & omissions, etc.  Our office regularly assists small business owners and real estate investors with all of the questions that should be asked when considering an LLC.  If you are not sure whether an LLC is an appropriate legal structure for your situation, please contact our office to schedule an appointment.