As the owner of a letterpress business, you likely have many issues that keep you up at night. From making payroll to meeting customer deadlines to fixing that old Heidelberg, your day-to-day worries can (and probably do) consume most of your available time. With worries of this sort, it is no wonder there is not much time left in the day to consider and take steps to minimize long-term risks; for example, the less obvious, less immediate worries that your business might be named in a lawsuit or, worse yet, that your business dealings might lead to claims against you or your personal assets. Perhaps you read about it while planning your business or maybe somebody planted the thought in your mind long ago, but concern for liability risk has never entered the fore of your day-to-day dealings. After all, you do not manufacture pharmaceuticals, operate a commercial airline, or run some other similarly high-risk business. But you do have a studio or shop with high powered equipments; you might have one or more employees, and you most likely enter into agreements with customers, vendors, and other third-parties. Activities like these present liability risk. Not to worry, though: now is as good a time as any to develop and implement a plan to guard against what could become a costly reality.
Liability primarily comes in two forms: criminal liability, where one is found guilty of committing a crime; and civil liability, where one has to pay money, perform a specific act, or refrain from a certain activity because they are judged to have harmed another. This article focuses on avoiding civil liability—liability that, although it may seem beyond your control, can be prevented.
Choosing a Business Entity Form
The likely first step in a liability protection plan is to carefully choose an appropriate form of organization for your business. Small businesses come in many shapes and sizes–from the sole proprietorship dealing in a single product or service to the large, privately held enterprise operating in diverse markets. Each form of business entity has specific attributes and each has its advantages and disadvantages. You should sit down with your attorney and accountant to help you weigh these attributes, advantages, and disadvantages in the context of your business before you ultimately determine which form is best suited for your particular objectives and situation. In order to provide you with a framework for those conversations, let us briefly explore the various different forms of business organization with an eye toward how certain forms can help protect against potentially costly liability.
A sole proprietorship is the most basic form a business can take. It is a business owned by a single individual who owns all of the assets of the business. A sole proprietorship can be created and operated without having to follow any formalities. There is no organizational structure beyond that of the owner; as such, the only requirement for bringing a sole proprietorship into existence is a decision by the owner to enter into business. Since the sole proprietor owns all of the business assets, he or she can make all management and other decisions related to the business without holding meetings, passing resolutions, taking votes, or following other similar formalities. The sole proprietor is also entitled to all of the profits and must shoulder all of the losses of the business.
Despite the ease of creating and operating a sole proprietorship, there is a significant downside to choosing this form of business organization: a sole proprietor is personally liable for all debts and liabilities of the business. For instance, the sole proprietor is liable for contractual obligations he or she entered into on behalf of the business. And if an agent or employee of the business incurs contractual obligations on behalf of the business, the sole proprietor again is liable. Similarly, in the event liability arises out of a wrong committed in the course of business dealings, the sole proprietor is liable for his or her own wrongs as well as those employees commit while performing their job functions. In each of these scenarios the sole proprietor’s liability, if established, has no bounds. Both the assets of the business and the proprietor’s personal assets are exposed.
Such exposure is one of the reasons there exists several alternative forms of business organization that cloak a business with a veil of protection. The most common of these alternatives are the limited partnership, corporation, and limited liability company. (There are, of course, other business forms that are available to the business owner such as a business trust or those forms typically reserved for professional services—limited liability partnerships or professional corporations, for example–but these forms are beyond the focus of this article.)
A limited partnership is an association of two or more persons who are co-owners of a business for profit, with at least one general partner and one limited partner. Two or more individuals or entities may form a limited partnership by filing the appropriate certificate with the Secretary of State of the state in which the business is to be organized. While it is common for the founders to enter into a written limited partnership agreement to describe how the business will operate, such an agreement is not necessarily required. The relevant state’s limited partnership law may control any matters not covered in a written agreement. For instance, state laws typically provide that a limited partnership’s profits and losses are shared by all partners in proportion to their capital contributions, but the partners may instead agree to a different allocation of profits and losses in a limited partnership agreement.
From a liability perspective, the principal feature of a limited partnership is the distinction between general and limited partners. General partners have exclusive control over management of the limited partnership and, as such, are personally liable for all debts and obligations of the business. The liability of a general partner is personal and is not limited to his or her investment in the business. Conversely, limited partners can have only restricted management rights (such as voting on certain major decisions) but enjoy limited liability for the business’s debts and obligations. As long as the limited partner does not participate in managing the business, the limited partner’s liability is limited to the amount he or she invested in the business—that is, he or she will not be personally responsible for the limited partnership’s debts and obligations. If a limited partner participates in the management or control of the business, however, he or she can lose the limited liability shield and become just as liable as a general partner for business debts and obligations.
A corporation is an artificial entity created under state (or, less often, federal) law. One or more individuals or entities may own the stock or shares of a corporation, thereby becoming shareholders or owners of the business. Each state has a detailed statutory and regulatory framework for the formation, operation, and termination of corporations. For instance, a corporation is generally created by filing articles of incorporation with the Secretary of State of the state in which the business is to be organized. Once formed, a corporation must issue stock and must install a management structure, consisting of a board of directors and officers, in order to operate the business. And a corporation must have formal written documents evidencing its compliance with these and other formalities. A corporation alone is entitled to its profits and losses, but the corporation may distribute profits as dividends to shareholders or make distributions upon a partial or complete liquidation of the corporation.
Shareholders do not have the right to participate in management other than to elect the board of directors, who in turn elect officers to carry out the board’s policies and directives. Although certain major corporate decisions require shareholder approval, day-to-day management is vested exclusively in the board of directors and its officers. Given this structure, the shareholders are not personally liable for the corporation’s debts and obligations; their potential liability is limited to the shareholders’ investment in the corporation. The hallmark of a corporation is that it alone is responsible for its liabilities. Assets of the corporation are available to creditors for their payment, and a shareholder’s investment is exposed only in the event corporate assets are exhausted in satisfying the corporation’s debts and obligations. A shareholder’s personal assets generally are not exposed.
There are, however, exceptions to the general rule of limited shareholder liability. If, for instance, a corporation is severely undercapitalized, is operating as a sham entity, or its shareholders otherwise fail to respect the corporation’s status as a separate legal entity, the liability veil may be pierced. A court that decides to “pierce the corporate veil” may then hold shareholders personally liable for the debts, obligations, and liabilities of the corporation. This is an extraordinary remedy that courts rarely invoke, preferring instead to reserve veil piercing for only the most egregious instances of undercapitalization or fraudulent corporate structuring.
Limited Liability Company
A limited liability company (LLC) is a legal entity formed under state law. An LLC is a hybrid business entity that combines the organizational and operational features of a partnership with the limited liability feature of a corporation, thereby making this form appealing to many business owners and particularly small business owners. Some states allow for LLCs to have only a single owner (or member), while others require at least two members. A member or organizer seeking to create an LLC must file articles of organization with the Secretary of State of the state in which the business is to be organized. As with limited partnerships, LLCs commonly have written agreements among members, called operating agreements, dictating the details of how the LLC will operate and terminate. State laws will typically cover any issues not specifically addressed in operating agreement.
Profits and losses do not remain with an LLC but instead are allocated to its members based on either the provisions of the operating agreement or the dictates of applicable state law, which may mandate that profits and losses be shared equally among members or in proportion to their capital contributions. Management of an LLC is the province of its members, who may appoint a member or members to manage the business. The members also have the right to be more passive in their ownership and designate a separate manager, who may or may not be a member, to be responsible for management of the LLC.
As owners of the LLC, all members are entitled to limited liability, regardless of whether they agree to participate in management of the business. Similar to a corporation, an LLC alone is responsible for its debts and obligations. And as with a corporate shareholder, an LLC member’s personal liability for the business’s debts and obligations is limited to the member’s investment in the company; the member’s personal assets are not exposed. But as with a corporation, if an LLC is undercapitalized, organized as a sham, or if its separate existence is otherwise not respected, a court may pierce the LLC’s limited liability veil and hold the members personally liable for the company’s debts, obligations, and liabilities.
Apart from a sole proprietorship, the business forms discussed above provide at least some form of limited liability to shield business owners’ personal assets and holdings from the claims of creditors or claimants of the business. Another important step in any liability protection plan is to consider purchasing liability insurance. Liability insurance can provide crucial protection to the business owner against litigation expenses and potential liability for injuries to people or property claimed to have been caused by the business or its employees. The available liability insurance coverage may vary from insurance company to insurance company, but coverage can generally be tailored to suit your specific business and protect against many of the risks and expenses associated with being sued.
For example, let’s assume a student visits your studio to learn how to use a press and injures himself while operating one of your machines. The student then files a lawsuit, naming both your business and you as defendants and claiming that you or one of your employees negligently maintained the press in such a way as to make it unsafe for operation. You, as a prudent business owner, had previously purchased a liability policy protecting you and your business against liability arising from claims that any agent of the business acted negligently in performing his or her job duties and covering the cost of defending against such claims. Even assuming the student’s lawsuit is ultimately found to be baseless, the legal costs of defending the suit to that point could be substantial. Your liability insurance carrier, however, will pick up the tab and cover the cost of any final judgment up to the policy limits.
Now, let’s further assume a few additional facts about the above scenario. First, your business is located and conducts its affairs in a jurisdiction that enforces properly drafted and executed liability waivers and release agreements. These agreements are tools that businesses may employ when trying to limit or eliminate business liability in the event a consumer is injured. Second, as an additional component of your liability protection plan, you ask students to review and sign such waivers and releases before participating in any activities at your studio. Your particular agreement asks any guest to give up certain rights in exchange for being able to take part in certain activities at your studio, including the right to sue you, your business, or any of its employees for injuries the guest might suffer while at your studio, whether caused by someone’s negligence or not.
There are several benefits to having had the student review and sign a waiver of liability agreement before he has an opportunity to suffer an injury. Chief among these benefits is the distinct possibility that, should the student be injured, he and/or his lawyer will review the agreement and decide, because he agreed to give up the right to sue, that it would be futile to file a lawsuit against you or your business. But even if the student initiates a lawsuit, the signed agreement can help bring the litigation to an early end, keeping litigation costs low and avoiding liability that might otherwise have existed. Either outcome is certainly more desirable than defending protracted litigation that could result in an adverse judgment.
By implementing a simple liability protection plan, comprised of protective measures such as those discussed in this article, you can remain focused on the work you love to do, while resting a little easier at night. Your personal assets are protected, you’ve taken the steps to ensure that your business can continue to operate, even in the face of litigation, and you’ve done what you can to avoid litigation in the first place.
The content of this article is for informational purposes only and is not legal advice or opinion. This article does not create an attorney-client relationship between the reader and Combs & Taylor LLP or any of its lawyers.