This post is the second in a series examining limited liability in the context of a new business. Previously, in the first post of this series, I provided a general overview of the different sources of liability, namely contract and tort liability. In this post, I’ll discuss the effectiveness of using entities providing limited liability protection (like corporations, LLCs, and limited partnerships), and discuss whether insurance may be sufficient liability protection in the context of a new business or whether an entity is needed.
Many lawyers seem to recommend a limited liability entity for any business venture. On the other hand, insurance professionals and CPAs often suggest that obtaining insurance may be enough. So who’s right? As I so often find myself saying with these types of questions, the answer depends on the specifics of the business involved. And in this case, there really is no definitive answer.
First, let’s take a couple of common examples where liability insurance may be enough to protect the client. One instance might be a client making a small real estate rental investment. Let’s assume that the client will have no employees and will manage the property himself. In this case, with respect to contract liability, the client will have personal liability as landlord under the lease, but the lease agreement itself can define and limit the landlord’s responsibilities and obligations. In the case of any debt incurred to acquire the property, most lenders in small real estate deals will require a personal guaranty if a limited liability entity is used. Therefore, in this context, a limited liability entity probably adds very little in terms of protection from contract liability.
So the real issue in this example is tort liability. Will a limited liability entity protect the client from tort liability? While it’s impossible to give an absolute answer to this question because of the variety of situations that can cause tort liability, it’s likely that there will be little protection added by a limited liability entity in this example. Under most (or perhaps all) statutes providing for limited liability, an individual is liable for his or her own actions, including negligent acts. And here, the individual has no partners or employees and thus it’s likely that any negligence will arise out of the individual’s own conduct (e.g. damaged steps that the landlord does not repair and which causes the tenant to fall and harm herself). Therefore, I think it’s unlikely that a limited liability entity would add much protection. I’m certainly not saying that it adds no protection at all, as I believe there is always some minimal level of protection provided when a lawsuit is filed and there is an entity in place. But in this case, the amount of protection may not amount to much.
A second similar example might be a consultant who has no employees or partners and merely provides consulting services. The same sort of analysis applies. Since the contract can define and limit the contract liability and almost all tort liability would result from the consultant’s personal negligence, a limited liability entity would provide little benefit.
On the other hand, let’s suppose the facts are such that the client is buying a multi-story apartment complex with three other individuals or starting a business with ten employees. In either case, there is much more risk to protect against, as the client has partners or employees and others whose acts may cause him to incur potential liability. So in this case, a limited liability entity would make more sense.
But what about insurance? Doesn’t insurance protect against all of these risks? Many clients seem to forget the very simple nature of an insurance contract which is that it is in fact a contract between two parties, the insurance company and the insured. And as with any contract, it only covers what the contract says it covers and it excludes what the contract says it excludes. “Having insurance” does not necessarily equal protection from everything under the sun. So my advice is typically to consult with a knowledgeable insurance professional and to have your insurance policy and endorsements reviewed by legal counsel.
Finally, the costs of implementing and maintaining the entity and associated taxes incurred as a result of the entity need to be considered. Generally speaking, implementing and maintaining an entity isn’t very expensive but there are up-front costs, annual filing fees, and there may be additional state taxes. For example, a Tennessee limited liability company costs about $300 to form (plus legal fees) and $300 per year payable to the Tennessee Secretary of State. In addition, having a limited liability entity may subject the earnings and assets of the business to taxes. For example, in Tennessee, the “Franchise & Excise Tax” will apply unless the entity falls within certain exemptions. Assuming the tax applies, the tax rates are as follows:
Franchise tax – $0.25/$100 of net worth (minimum of $100 per year)
Excise tax – 6.5% of net earnings of the business
To sum up, the decision of using an entity or not requires a cost benefit analysis. As a general rule, if you’re starting a business and do not plan to have other partners or employees, then I would recommend taking a hard look at what protection (if any) a limited liability entity might. On the other hand, if you plan to have partners or employees, then I would generally suggest having an entity. However, in either case, I would consider costs of implementing and maintaining the entity in light of the protection added.
———————————
This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
