How “limited” is “limited liability”?

One of the primary benefits of incorporation or formation of a limited liability partnership or company is the feature of limited liability — the liabilities of the business are the business’ alone, and the scope of owners’ exposure is limited to whatever capital they have invested in the business, keeping their personal assets safe. But in practice, how limited is the limited liability shield of corporations and unincorporated business organizations?

The fact of the matter is, limited liability shields, especially for new small businesses, may not provide all the protection you think it does. As a new small, start-up business with no proven track record of customers or cash flow, many persons or organizations that the new business will deal with may likely require the owners to personally guarantee the liability of the business. Once an owner personally guarantees a business’s liability, in the event that the business cannot satisfy those liabilities, the obligee may pursue the guarantor to satisfy the liability.

While many smaller liabilities, such as supplies, utilities, or a corporate credit card may be kept solely in the business’ name, owners of start-up businesses may be required by commercial landlords to guarantee leases for office or retail space, or required by banks to act as sureties for commercial loans. Third parties a start-up business owner will deal with may likely only accept the business as the sole liability holder, if at all, once the business has established itself as viable, with good cash flow and/or sufficient assets.

In addition, a limited liability shield does not shelter owners from liability they personally incur, in particular tort liability, even if such liability is incurred in the course of business operations. For example, an owner getting into an car accident in a company-owned car, driving on company business, is nonetheless personally liable for the damages and injuries he or she caused. And because owners of start-up businesses are generally directly involved in the day-to-day management of their businesses, including hiring and supervising of employees, even if tort liability is accumulated by employees, owners may nonetheless be liable under negligent employment/entrustment theories.

Furthermore, owners of small businesses must be careful not to undertake actions that can jeopardize the limited liability shield in a process known as “piercing the corporate veil”. Business organizations are considered, to one extent or another, entities separate from their owners — corporations especially are considered to have legal “personhood”. In the event that owners fail to recognize corporate formalities by, for example, not holding organizational meetings required by law or co-mingling personal and business funds, a plaintiff in a civil suit may ask the court to “pierce the corporate veil” and subject the personal assets of some or all of the owners to satisfy a judgment. Although courts have mostly applied the “piercing the corporate veil” doctrine to corporations, the general consensus among lawyers is that a court would also apply the same doctrine to unincorporated business organizations, with a legal standard reflecting the more informal management structure of many unincorporated business organizations.

Practically speaking, there are many kinds of liability that business owners cannot be protected from by limited liability shields, but can be mitigated against. Personal liability for commercial leases or loans can be minimized by careful planning and negotiation; personal tort liability can be minimized by a good insurance policy. And of course, owners should be careful to remember to treat their businesses as separate legal entities to avoid the risk of a court “piercing the corporate veil” in a civil suit.

The question then becomes — it is worth the time and expense to set up a limited liability business organization? Limited liability is relatively easy to obtain — corporations and limited liability companies automatically have limited liability shields, and is easy for partnerships that are eligible for limited liability to obtain it. Unless business considerations exist that dictate the selection of a business for not automatically endowed with limited liability, such as a general partnership, or ineligible for limited liability, such as a limited partnership (in Massachusetts; in some other jurisdictions limited partnerships are eligible for limited liability), there is no reason why start-up business owners shouldn’t take advantage of any protection that a limited liability shield can afford. Those owners should, of course, remain cognizant of the practical limitations of the limited liability shield.