How does Liability Protection work in an LLC?
The term “LLC” signifies a Limited Liability Company, referring to a business structure similar to a corporation. Unlike its counterpart, this business structure is a simplified approach as it makes management easier for the business owner. Basically, an LLC is a business type that has extracted the Liability protection principle from Corporations and applied it to a smaller business structure. On the whole, an LLC is not a corporation, yet it gives you the same liability protection as a corporation.
What is Limited Liability?
With Limited Liability, the owners of the LLC have the upper hand as they are not personally liable for the operation of the company. This legal structure can incur its own debts and liabilities and can have its own assets and financial history. In a Limited Liability Company, although the owners are considered the operators, they are not responsible for the obligations of the company. Therefore, the personal assets of the owners can not be held liable to satisfy the company’s debts or legal obligations in case the company gets sued. This separation between the business and personal assets of the owners provides a degree of security and risk mitigation for individuals starting or investing in a business.
When Can Liability Protection be circumvented?
The following 3 methods can be employed to circumvent the liability protection offered by the LLC:
When the owners of an LLC voluntarily agree to a personal guarantee clause within a contract, it effectively nullifies the liability protection typically provided by the LLC structure. A personal guarantee is a commitment made by the owners of a business to a third party, stating that if the business cannot fulfill the terms of the contract, the owners themselves will personally take responsibility for meeting those obligations. In essence, under the terms of the contract, they are essentially giving up their liability protection.
For instance, landlords often require the owners of the LLC to sign a personal guarantee before allowing the LLC to lease the office space. Landlords will not let a new LLC sign an office lease unless the owners guarantee the lease in case the company cannot afford to pay it. In this situation, the owners have given up their Liability protection concerning the lease terms.
As a result, it is important for the LLC owner to be mindful of the personal guarantee clause if it is a part of a contract. Owners must make an informed decision about whether they are willing to assume the risk of personal liability if the business cannot meet the contractual requirements.
2) Fraud or Negligence
The liability protection provided by an LLC can be bypassed if the company owners engage in fraud or negligence. It is important to note that proving such actions is quite a challenging task, as the opposing party needs to have evidence that the owners’ actions were clearly outside the regular course of business and that they were the primary cause of the issue. However, the owners can be held personally accountable if they consciously perform activities outside their normal scope of work that cause the problem.
Example of Fraud or Negligence:
Suppose an LLC operates a limousine company, and one of its vehicles crashes into a building, causing extensive damage. Are the owners personally liable for the damage?
Certainly not, as the accident occurred during the regular course of the company’s business activity. Nevertheless, if the opposing party is able to prove one of the following items, they can make the LLC owners liable for the damage:
- The driver was improperly licensed to operate the vehicle.
- The owners of the company knew that the driver was too tired to drive, leading to the accident.
- The owners of the company knew about the vehicle malfunction but did not address it, which could have caused the accident.
In short, if the opposing party is able to prove that the owners of the company knowingly made decisions that put others at risk, they can lose the protection of limited liability.
Inappropriate Operation of LLC
Owners of an LLC can be held personally liable for the company’s debts if the third party can prove the inappropriate operation of the LLC. The following listed are a few examples of activities that could lead to the circumvention of liability protection:
- Owners use their personal bank accounts for the company’s income and expenses.
- Owners incorrectly report all income and expenses on their personal tax returns instead of their business tax returns.
- Owners incorrectly use the Employer Identification Number (EIN) of the business.
- Owners continued business operations even after the suspension of the LLC’s legal status.
In all of these examples, the company owners have failed to adhere to the proper business practices and blurred the lines between their personal affairs and the business. They conducted the business operation while the business structure itself was not used. This misconduct can lead to a loss of the liability protection provided by the LLC structure.
Let an Expert Help you – BusinessRocket
Although the above guide was written to give you a better picture of the intricacies of liability protection along with how it applies to an LLC business structure. However, it can be challenging for a start-up business to handle it alone. Therefore, if you are in search of a platform that can guide you toward liability protection and other business-related licenses, consider taking advantage of the expertise of our skilled team. BusinessRocket is your answer to every business entity formation question for start-ups. If you have any additional queries related to liability protection and how it applies to an LLC, feel free to call our office at 310-424-5558 Extension 1. Our helpful onboarding team will help you with all of your doubts.
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