Why Having an LLC or Corporation is Better than Insurance Alone

Today I was reading a well-intentioned article about moving from a Sole Proprietorship to a Limited Liability Company that touched on a pet peeve of mine — financial advisors who tell small businesses that liability insurance is a substitute for incorporating or forming an LLC. 

Disclaimer: This article is for discussion only and is not legal advice. The laws about Limited Liability Companies vary by state and can change from time to time, so you should consult an attorney in your state and do not rely on this article as legal advice.

For many years it has been incredible to me that lots of CPAs tell small business clients “don’t incorporate or form an LLC, just use insurance”.  This is some of the worst advice that you will get for several reasons.

Let’s be clear from the start: nothing you do will prevent you from being sued.  In the United States, we have open access to the courts and anyone with a piece of paper and the court filing fee can sue anyone else. However, what a small business owner really is looking to do is to keep from being found by a court to be personally liable for damages that a court might eventually find that are owed to the person filing suit (the Plaintiff).

If handled properly, an LLC or a corporation may very well provide an extra layer of protection from having personal liability. We speak generally of the “corporate shield” or the “corporate veil”, in that the law treats corporations and LLCs as separate entities, and normally the liability stops at the entity level (meaning an individual’s personal assets would be protected).

This can be true even if it is a one-person LLC or corporation. That fact alone is not automatically enough for a court to “pierce the corporate veil” and hold an individual liable for the acts or omissions of the corporation/LLC. However, and I believe this is where some confusion comes in, a court can find an individual liable under a few circumstances, most commonly: (1) Where corporate formalities have been ignored; and (2) Where an individual has acted outside of the scope of the power their position with the corporation/LLC affords them.

Corporate formalities — o.k., so you’ve got an LLC or corporation, but you’re mixing LLC funds with your personal funds in the same account (or paying your home expenses from your LLC account), you are failing to keep any separate LLC/corporate legal documents, or you are otherwise acting as if the corporation/LLC is just your personal “alter ego”.   Or perhaps you take every bit of cash out of the LLC/corporation so that it is a mere shell with no assets of its own. In a case like that, a court may find the LLC/corporation is a mere sham or dummy corporation and hold an owner personally liable.

Scope of Position — whether you are a Fortune 500 company or a 1 person LLC, if you act outside of the scope of your normal powers/duties then you won’t necessarily be protected. So, if you’re an Enron exec or 1 man company who are INTENTIONALLY committing fraud on others, the corporate shield won’t keep you free from personal liability. However, if you run a series of calculations and NEGLIGENTLY make a mistake — making a negligent misrepresentation to a creditor or investor, having an LLC or corporation could protect you from personal liability in that type of case.

So, in summary, an LLC or corporation can sometimes protect you against accidents and mistakes (negligence), but likely won’t protect you from intentional and/or criminal misconduct. And there are many shades of gray in between.

One more big reason liability insurance is not enough: most insurance policies have so many exceptions to coverage that they are like Swiss cheese, and in many cases an insurance company will try to escape coverage. These usually include exceptions for intentional misconduct or crimes, and often include certain types of negligence — and many time exclude liability for punitive damages (where you can get the biggest liability).  There could very well be some liabilities than an LLC/corporation would protect you from, though insurance would not.

Therefore, to protect yourself as fully as possible, it is best to take a “belt and suspenders” approach and both have insurance AND have an LLC or corporation in place, and follow the formalities that are required.

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