As the name implies, limited liability companies (“LLCs”) are limited liability entities that protect their owners (also called members), managers, and the LLC itself from certain types of legal liability. But just what is this limited liability, and how limited is it really?
What Type of Liability Protection Do You Get With an LLC?
The main reason people form LLCs is to avoid personal liability for the debts of a business they own or are involved in. By forming an LLC, only the LLC is liable for the debts and liabilities incurred by the business—not the owners or managers. However, the limited liability provided by an LLC is not perfect and, in some cases, depends on what state your LLC is in.
Before you get started on your business venture, you’ll want to consider the potential liability risks of your business and the protection you’ll get from an LLC. Specifically, you should think about the following liability risks you take on as an LLC owner:
1) personal liability for your LLC’s debts
2) personal liability for actions by LLC co-owners or employees related to the business
3) personal liability for your own actions related to the business, and
4) the LLC’s liability for other members’ personal debts.
Personal Liability for Your LLC’s Debts
In all states, if you form an LLC to operate your business, and don’t personally guarantee or promise to pay its debts, you will ordinarily not be personally liable for the LLC’s debts. Thus, your LLC’s creditors can go after your LLC’s bank accounts and other property, but they can’t touch your personal property, such as your personal bank accounts, home, or car. Many creditors, however, don’t want to be left holding the bag if your business goes under so they will demand that you personally guarantee any business loans, credit cards, or other extensions of credit to your LLC. In that situation, you would be personally liable if your LLC’s assets fall short.
Personal Liability for Actions by LLC Co-Owners and Employees
In all states, having an LLC will protect owners from personal liability for any wrongdoing committed by the co-owners or employees of an LLC during the course of business. If the LLC is found liable for the negligence or wrongdoing of its owner or employee, the LLC’s money or property can be taken by creditors to satisfy a judgment against the LLC. But the LLC owners would not be personally liable for that debt. The owner or employee who committed the act might also be personally liable for his or her actions but a co-owner of the LLC who was not involved in the act or wrongdoing would not be.
Example: While making a bread delivery to a local supermarket, Lloyd, an employee of the Acme Bakery, LLC, runs over and kills a brain surgeon in a crosswalk. It turns out Lloyd was driving while drunk. Acme Bakery is sued and found liable for its employee’s negligent actions while on the job. All of Acme’s business property, assets, money, and insurance can be used to pay the judgment awarded to the surgeon’s heirs. Acme LLC’s owners, however, are not personally liable for the LLC’s employee’s actions so their personal assets cannot be taken to pay any judgment against Acme.
Personal Liability for Your Own Actions
There is one extremely significant exception to the limited liability provided by LLCs. This exception exists in all states. If you form an LLC, you will remain personally liable for any wrongdoing you commit during the course of your LLC business. For example, LLC owners can be held personally liable if they:
- personally and directly injure someone during the course of business due to their negligence
- fail to deposit taxes withheld from employees' wages
- intentionally do something fraudulent, illegal, or reckless during the course of business that causes harm to the company or to someone else, or
- treat the LLC as an extension of their personal affairs, rather than as a separate legal entity.
Thus, forming an LLC will not protect you against personal liability for your own negligence, malpractice, or other personal wrongdoing that you commit related to your business. If both you and your LLC are found liable for an act you commit, then the LLC’s assets and your personal assets could be taken by creditors to satisfy the judgment. This is why LLCs and their owners should always have liability insurance.
Example: Assume that two of the three owners of Acme Bakery LLC (from the example above), knew that their driver was drunk, but let him make deliveries anyway. They can be sued and held personally liable for negligence by the brain surgeon’s heirs.
Your LLC’s Liability for Members' Personal Debts
An LLC’s money or property cannot be taken by creditors of an LLC’s owner to satisfy personal debts against the owner. However, instead of taking property directly, there are other things that creditors of an LLC owner can do to try to collect from someone with an ownership interest in an LLC. What is allowed varies state by state and includes, in order of severity, the following:
- getting a court to order that the LLC pay to the creditor all the money due to the LLC owner/debtor from the LLC (this is called a “charging order”)
- foreclosing on the owner/debtor’s LLC ownership interest, or
- getting a court to order the LLC to be dissolved.
None of these actions are good but some are much worse than others. If an LLC interest is foreclosed upon, the foreclosing creditor becomes the permanent owner of all the debtor-member’s financial rights, including the right to receive money from the LLC. If a court orders an LLC dissolved, it will have to cease doing business and sell all of its assets.
State LLC laws vary widely on how many of these steps creditors are allowed to take. All states allow creditors to obtain a charging order against an LLC owner's interest. Many states limit creditors remedies to this first step (obtaining a charging order). Other states allow creditors to foreclose on the owner’s LLC interest or even can order the LLC dissolved to pay off an owner’s debt. For more on charging orders and what personal creditors' of LLC owners can--and can't--do, including the state law variations, see LLC Asset Protection and Charging Orders: An Overview of State Laws.
Single Member LLCs and Asset Protection
In some states, it's not clear whether single member LLCs ("SMLLCs") will receive the same liability protection as multi-member LLCs. The rationale for limiting an LLC member's personal creditor's remedies to a charging order is to protect other LLC members from having to share management of their LLC with an outside creditor. There are no other LLC members to protect in a single member LLC so the rationale for limiting creditors' remedies to a charging order doesn't apply. For this reason, courts in some states have found that single member LLCs are not entitled to the charging order protection and creditors are entitled to pursue other remedies against the LLC member, including foreclosing on the member's interest or ordering the LLC dissolved to pay off the debt.
Check Your State Laws on LLC Protection for Members' Personal Debt
To see how each state deals with the issue of personal creditors' rights and LLCs, follow the link below: