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Alabama Limited Liability Company Benefits: Limitation of Liability

Author: Brenton McWilliams

Probably the number one reason businesses choose to form a limited liability company are the limitations of liability provided for the owner (member). Subject to some limitations, a limited liability company owner is not personally responsible for liabilities incurred by the LLC.

A contract or loan made by the LLC is a simple scenario to use as an example. The LLC has obligated itself to perform the contract or pay back the loan. The LLC functions as an entity separate from its owner. If the LLC defaults on the contract or loan, the LLC must pay any judgment using the assets or income held by the LLC. However, if the LLC does not have sufficient assets or income to pay the judgment (or for the judgment creditor to collect from) the owner or owners (members) normally would not be required to use their own personal assets held outside the LLC to pay the judgment.

This example is useful for explanation purposes, but it’s usually not the way things are realistically done with start-up or small business LLCs. Typically, a bank or other company making a loan or contract with an LLC will require at least one of the owners of the LLC to sign the contract or loan in their personal capacity (commonly referred to as a personal guaranty). The owner personally obligates themselves to pay the loan or perform the contract. In this situation, since the owner has separately signed onto the contract in an individual capacity, both the LLC and the owner are parties to the loan or contract.

Where the liability limitations work in favor of the LLC owner, they work against the party contracting with the LLC. To mitigate against the potential of a default with no assets to collect from, the party contracting with the LLC typically wants an actual person (who has debt free collateral and future income potential beyond the LLC) obligated to pay any default. Since both the owner and the LLC are parties to the contract, the owner would be personally liable in case of default and, therefore, required to use personal assets and income outside of the LLC to satisfy any default or judgment.

The limitation of liability also applies to torts: personal injury claims, car wrecks, truck accidents, negligence and wrongful death are a few examples. However, there is a common misconception that the formation of a limited liability company will exonerate the owner from liability for any personal injury torts. The owner is shielded from being personally responsible for liabilities imposed on the LLC. However, the LLC does not shield the owner from being personally liable for personal injuries caused by the owner.

A limited liability company is a fictitious business entity. Although the law in some ways treats it similar to a person, a limited liability company is obviously not an actual person. Most of the limited liability company’s activities must be carried out by an actual person. For example, a limited liability company cannot drive a car. An employee of an LLC can drive a car while working for the LLC, but the LLC itself does not drive the car.

Since the limited liability company carries out acts through others, tort liability is usually imposed on a limited liability company through some form of vicarious liability. Vicarious liability is a general term used to refer to the legal doctrines which can make one person (or business entity) liable for the acts of another person. In a business setting, the doctrine of respondeat superior (“let the master answer”) is a very common form of vicarious liability. Under respondeat superior, an employer can be held liable for the acts of its employee carried out in the scope of employment. Back to the employee driving a car for the LLC: if the employee negligently operates the car and causes an accident, both the employee and the LLC can be held jointly liable for the injuries resulting from the accident.

If that employee also happens to be the owner (which is often the case in startup and very small businesses), the owner will still be personally liable because the owner’s negligence caused the accident. Because the owner was driving the car in the scope of employment with the owner’s own LLC, liability will also be imposed on the LLC through vicarious liability.

However, assuming the employee is someone other than the owner, liability would be imposed on the employee for the employee’s own negligence and on the LLC through vicarious liability. In this situation, the limitation of liability benefits of the LLC would shield the owner from personal liability for the vicarious liability imposed on the LLC.

The limitation of liability benefits of a limited liability company provide protections for an owner’s (member’s) assets held personally or otherwise outside of the LLC. In the next article, I’ll discuss the asset protection benefits of an LLC which protect the assets held within the LLC.

For more information about limited liability companies, see my other articles including a basic explanation of limited liability companies and how a limited liability company is managed. Both of these articles would be helpful for anyone considering forming a limited liability company or making changes to an existing limited liability company. Also take a look at the blog page for other articles on business law and other topics.

If you’re considering forming a limited liability company, making changes to an existing limited liability company or if you need legal advice for your business, please call me at (251) 215-9275 or write me on the contact page to discuss how I can help.