The Limitations of Limited Liability

Most business owners understand the importance of limited liability protection. It is a simple concept.  Limited liability protection shields business owners from personal responsibility for their company’s debts and liabilities. Not all forms of companies offer this protection however.  Sole proprietorships and partnerships do not.  Corporations, limited liability companies, and limited partnerships are among the entities that do offer limited liability protection.

The concept of limited liability is rooted in the status of a corporation as its own separate entity, meaning that the company is recognized under the law as being distinct from its owners. Corporations, however, did not always provide owners with limited liability.  At the start of the nineteenth century, direct shareholder liability in the United States was still common. See, Limited Liability and Corporate Groups, 11 J. Corp. L. 573, page 588. This began to change in the first few decades of the nineteenth century when cases in the United States began to hold that shareholders were not directly liable for corporate debts unless a state statute or the company charter expressly provided for such liability. Id. at 592. In addition, at that time, various states began to enact statutes that provided limited liability for corporations. Id. at 593.  The popularity of limited liability continued to rise and is commonplace today.  Despite its wide-ranging acceptance, as discussed below, there can be personal liability for shareholders and owners in certain circumstances.

There are a number of ways that a business owner can fail to be protected by limited liability.  The first is not being properly formed in the first place.  Many business owners may not realize when their business entity is not properly formed.  For instance, just having an EIN from the IRS or having an operating agreement for a limited liability company does not mean that the company exists as its own separate legal entity.  The proper paperwork must be filed with a state before the company is actually formed under the law.  Without this paperwork, the company does not exist as a separate entity.

Another way in which an owner can be subject to a company’s liability is through negligence.  If an owner provides primary services for a business and commits an act of negligence, the company and the owner can be held liable.  An owner can also be personally liable for a company’s debts if the owner gives a personal guarantee for business debts. This is often the case for smaller or start-up businesses where creditors require additional protection.

Even if the above circumstances do not apply, an owner can lose limited liability protection through the application of the legal doctrine of “veil-piercing.” This doctrine was first developed to prevent injustice resulting from limited liability under the principals of corporate law and has now been extended to other types of entities that possess limited liability. It is used to “pierce the corporate veil” of the entity and impose liability upon a company’s owners. Because it is an equitable remedy, courts look to what is equitable under the circumstances and as a result, its application is very fact specific. A court will look at a number of factors to determine whether it should apply the doctrine, such as whether corporate formalities have been disregarded, whether there has been a comingling of personal and corporate assets, whether the company is undercapitalized, whether the company is a just an instrumentality of another person or corporation and serves no legitimate business purpose and whether there has been fraud. Owners should be careful to avoid these circumstances so that this doctrine will not be applied.

Business owners should also be aware that certain state and federal statutes can impose liability upon owners, including statutes dealing with tax and environmental liability.

In sum, business owners protected by limited liability should become knowledgeable of the circumstances under which liability could be imposed upon them and take steps to limit the risks of such imposition.

By: Janine M. Lloyd, Esquire
Associate at Brown & Connery, LLP