The Limits of Limited Liability - Austin Estate Plan

Owning a business involves risk. There are no guarantees that the founders of a company will get along, a product or service will sell, or market conditions or competitors will not create unanticipated barriers. While entrepreneurs must be willing to take a leap of faith, there are steps they can take to reduce risk, both for the business and themselves. When forming a business, entrepreneurs can choose a legal structure with limited liability. By legally separating the business from themselves, owners can separate their personal assets from company liabilities. This “asset protection” becomes particularly important if the company faces financial distress. Limited liability is not limitless, however.

The Meaning and Purpose of Limited Liability

The general rule when creating a limited liability entity is that the business owners may lose only the money they invest in a company and any additional contributions they agree to when executing the Operating Agreement. Owners are not personally liable for any debts or obligations of the company. Instead, company creditors can only look to the business’s assets, not the individual owner’s assets.

Three common types of modern business structures provide limited liability:

limited liability company (LLC)
limited liability partnership (LLP)
corporation

It is taken for granted today that owners of a business entity are not responsible for the debts and actions of the entity. Indeed, modern capitalism is unimaginable without limited liability. But limited liability as we know it only dates back to around 1800 and the modern day “LLC”, today’s go to entity choice, has only been around since 1977.

Limited Liability Origins

An early predecessor of the limited liability structure was the joint-stock company, which has its roots in European exploration of the Americas. Trips to the New World were expensive and dangerous. Entrepreneurs of the day came up with a new business plan. They sold stock in companies that were engaged in voyages to the New World to wealthy individuals, who provided capital in exchange for a portion of the profits but were not responsible for the company’s actions.

The settling of the American colonies is closely tied to English joint-stock companies of the 1600s. Today, joint-stock companies no longer exist. But the legacy of these early limited liability companies lives on in corporations, LLCs, and LLPs.^[1]

The Limits of Limited Liability – Clerical Error, Statutory Imposition and Personal Conduct/Guarantees

Bifurcation of business and personal assets—the cornerstone of limited liability legal structures—is not absolute. Although courts are generally hesitant to impose personal liability on a company’s owners, they may do so in some situations, such as the following:

The limited liability business entity was not properly formed (e.g., because the appropriate paperwork was not filed with the state, and thus the separate legal entity was never formed).
A business owner’s negligent or reckless actions cause injury to another person.
The owner personally guarantees a loan or other company obligation and the company subsequently defaults.
A state or federal statute imposes liability on the owners (e.g., laws related to environmental and tax liability).

The Limits of Limited Liability – Piercing the Corporate Veil

In addition to the liabilities described above, Piercing the Veil of the limited liability entity is also an area which may bring significant risk to a business owner. Piercing the Veil is a judicially imposed remedy where the court ignores the liability “shield” offered by a limited liability entity and imposes company owners with personal responsibility for company obligations. Typically, courts will not pierce the veil simply because a business creditor will otherwise go unpaid. Instead, veil piercing requires evidence that the company was somehow used to perpetuate fraud or abuse the limited liability structure. For example, the court may decide that veil piercing is appropriate in the following scenarios:

A company was knowingly formed with insufficient capital to meet its contractual obligations and normal business functions (undercapitalization).
The business entity is a mere instrument for transacting the personal affairs of the owners/shareholders/members/partners and serves no legitimate purpose.
A company failed to follow compliance requirements or respect business formalities. Examples include failing to file required annual reports, holding annual meetings, obtaining or renewing business licenses, or having a registered agent.

How to Maintain Limited Liability

Keeping the limited liability of a corporation, LLC, or LLP intact requires knowing and preventing the circumstances that can eliminate the liability shield. Specifically, business owners should understand the following and do their best to follow these steps in order to limit personal liability:

File the appropriate paperwork with the state at the time of business formation.
The Company should ensure it is well capitalized at inception and thereafter for ongoing business operations. The Company should also make sure it is well insured for risks and liabilities that naturally flow from operations. For example, if a business operates a fleet of vehicles, make sure the fleet is well insured.
Business owners should take time to title business and personal assets appropriately. Once titled, owners should limit use of the assets to their titled purposes (business assets are used for business, personal assets are for personal use). Don’t take distributions if it will strap the business of cash to pay ongoing and known liabilities. Don’t engage in fraud or other intentional bad acts. Intentional bad acts are an invitation for imposition of personal liability for business debts.
Don’t lightly agree to guarantee business debt. Lenders may insist on a personal guarantee, but it never hurts to ask whether a guarantee is absolutely necessary. But remember, if an owner agrees to guarantee business debt, they risk their personal assets to the extent of the guarantee.
Some laws, such as the federal Superfund law,^[2] impose owner liability (owners should also be aware of available defenses, such as acts of God or war in the case of Superfund liability).
Respect business formalities that make veil piercing less likely. To that end, hold regular board/owner meetings (at least annually), maintain detailed books and records, don’t use the company checking account to pay for personal bills, avoid commingling personal and company funds or other hard assets, make all required filings on time; and obtain all required licenses and consents to operate the business. Once any necessary licenses are acquired, make sure to renew them when required.

Get Help from Our Attorneys

The limited liability of corporations, LLCs, and LLPs is generally only disregarded in extreme cases. While risk can never be eliminated altogether, if a business owner respects the boundaries between his/her personal assets with those of the business, implements good business practices, and the business is well capitalized and insured, then a business owner will be in a much better position to avoid personal responsibility for business debts and obligations. If you need help with business planning, including assistance with building better ongoing business structure and operating practices, we can help. Nielsen Law PLLC provides family focused estate and business planning to individuals and families in Austin, Round Rock, Cedar Park, and the Central Texas area. For more information, and to learn about our firm, please contact us. We look forward to working with you.

[1] Will Kenton, Joint-Stock Company: What It Is, History, and Examples, Investopedia (Jan. 15, 2023), https://www.investopedia.com/terms/j/jointstockcompany.asp.

[2] U.S. Env’t Prot. Agency, Superfund Liability, EPA.gov (Jul. 25, 2022), https://www.epa.gov/enforcement/superfund-liability.