Limited Liability - Is Incorporation Necessary Or Sufficient?

Shareholders of a corporation or members of a limited liability company (LLC) must maintain financial integrity and organizational formalities in order to enjoy the full limited liability protection which comes with having a formal business entity. Without proper capitalization, without maintaining proper minutes and corporate records, and without maintaining a strict wall of separation between the funds of the business entity and the funds of the business owner, a savvy creditor may be able to "pierce the corporate veil" of the corporation or LLC, and thereby obtain personal liability upon the business entity’s shareholders or members.

But an assessment of a business entity’s limited liability protection does not end with organizing as a corporation or LLC and avoiding the pitfalls that might result in piercing the corporate veil. Beyond these issues, and sometimes before making the decision to incorporate or organize an LLC, other questions must be asked. First, is incorporation or the organization of an LLC the only way to protect the owners of a business from personal liability? Second, is incorporation or organization of an LLC sufficient?

Is Incorporation Necessary?

Let us be careful not to overstate the question. Incorporation or organization as an LLC can almost always provide some additional measure of liability protection. However, with many small businesses, the owner already has some measure of liability limitation, and in many cases, the owner is not even aware of these liability limitations. For instance, if the owner of the small business has an interest or an investment in an unrelated partnership governed by the Pennsylvania Partnership Act, that partnership property is not subject to attachment on a judgment against the business owner. In other words, partnership property is exempt from attachment by the creditors of individual partners.

More significantly, Pennsylvania law provides that property owned by husband and wife, known as entireties property, is also exempt from attachment by the creditors of either spouse. This is because under Pennsylvania law property owned together by a husband and wife is exempt from attachment by a creditor who has a claim against only one of the spouses. As a result, the owner of a small business already has a very significant measure of limited liability protection if his or her non-business assets are titled jointly with his or her spouse. By the same token, it is often a bad idea to have a mom-and-pop business actually owned by both mom and pop given that a creditor of the mom-and-pop business may be able to seek recourse against mom and pop’s house.

Finally, as a practical matter, if the owner of the business owns little or nothing else besides the business, this too is a de facto limitation on the business owner’s personal liability. In short, you cannot get blood from a stone. While the business owner’s lack of other available assets is technically a limitation on the creditor’s ability to execute on a judgment rather than a limit on the business owner’s personal liability, the practical effect can be similar. Still, getting back to the larger picture, organization as a corporation or LLC can provide even the impoverished business owner with the peace of mind to know that a creditor of the business will not someday come knocking at the owner’s front door.

Is Incorporation Sufficient?

What if the owner of a small business is also its sole employee, holding every position from president down to chief cook and bottle washer? In this case, organization of the business as a corporation or LLC will have some benefit, but maybe not the full benefit which the owner expects. For instance, what if the sole shareholder/sole employee is negligent in causing a motor vehicle collision during the course of his employment for the company, resulting in injury to a third party? Let’s assume that the third party’s claim exceeds the value of any motor vehicle insurance coverage. Certainly, the corporation itself is vicariously liable for the negligence of its employee. However, the employee, who also happens to be the sole shareholder, would also be independently and personally liable for the injuries, regardless of the incorporation. In other words, incorporation does not absolve an individual of responsibility for his own personal acts. Thus, the limited liability of the corporation leaves the shareholder with a very hollow victory in a situation where the shareholder is personally liable anyway.

So even if a business is incorporated or organized as an LLC, it will still be necessary to maintain adequate liability insurance, insuring both the corporation and its employees with coverage amounts adequate to insure against potential losses. Companies should consult with their legal and insurance professionals to address the nature and adequacy of the required liability coverages.

Contract liabilities present a different problem. The problem arises where a new corporation or LLC seeks to lease or purchase real estate or a significant item of equipment. In these cases, any savvy seller or lessor will require that the individual shareholder (and perhaps his or her spouse as well) co-sign on the lease or purchase. That is, just as no one would extend credit to a newborn baby, few creditors will extend credit to a newly hatched corporation or LLC without the deal being co-signed by someone with a credit history. Unfortunately, the practical necessity of co-signature will eliminate the shareholder’s limited liability as to that particular transaction.

It is important to keep things in perspective. Incorporation or organization as a limited liability company has definite benefits. But it is not the only way, and should never be viewed as more than a significant part of an overall plan for limiting and controlling liability. For a more thorough assessment of liability limitations for your business, make an appointment today to consult with an attorney from Wolf, Baldwin & Associates, P.C.. We look forward to hearing from you.

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