The Limits of Limited Liability
Formal legal entities like corporations and LLCs serve a number of purposes. They enter into contracts, own property, and can offer favorable tax treatment for some transactions. They offer multiple owners an efficient way to allocate rights. They can sue and get sued. And they also bear all of the responsibility for their obligations, whether to lenders, other businesses, or opponents in litigation. This last point—limited liability—is a significant benefit a freelancer gains by forming a legal entity.
Although limited liability sounds good at first blush, it is important to understand that this protection has boundaries. A business owner sometimes has to assume personal responsibility for a business obligation as part of a deal. An owner can also make mistakes that negate limited liability. Let’s look at how voluntary and involuntary personal liability works.
Voluntarily Accepting Personal Responsibility (on purpose or by mistake)
A common way that a business owner ends up personally responsible for the debts of a limited liability entity is by directly assuming the company’s debts. Let’s look at three ways this can happen. The first way is to take on obligations as a sole proprietor before organizing a limited liability entity. The second way involves deliberately accepting personal risk for the business’s obligations, through personal guarantees requested by clients or service providers. The third way involves accidental obligations that can arise from sloppy paperwork or loose talk.
Obligations Assumed before an Entity’s Formation
Bear in mind that before a legal entity is formed, any actions you take on behalf of your business will be as a sole proprietor, without any limited liability protections. You continue to “own” these obligations even after a new legal entity is formed unless they can be assumed by the new legal entity. Your existing contracts will need some attention.
Some contracts may not be assignable at all. Boilerplate consumer contracts like cell phone service agreements tend to be strict on this point. You might consider letting such contracts expire at the end of their terms, so the company can enter into replacement contracts. Meanwhile, you will be personally responsible for the unassignable contracts. Be sure to account for your expenses under these business-related contracts so that their costs remain deductible.
If a contract doesn’t expressly prohibit assignment, it is necessary to get the counterparty to agree to two distinct things: the assignment of the contract to the new company and the new company’s assumption of the sole proprietorship’s existing obligations. Sometimes your counterparties will prefer to enter into new contracts rather than assign the old one. Bear in mind that when this is done your personal obligations as a sole proprietor continue unless the new contract states otherwise. Whether it’s worth fighting over this issue will depend on the circumstances. If your old contract exposed you to significant risk, it is worth fighting for assignment.
Another source of preformation liability is commitments made in the name of a legal entity that hasn’t been formed. Until the entity exists it can’t enter into a contract, so the person who signs on behalf of the still-unformed company becomes personally responsible. Here’s an example. Ima Freelancer has submitted the paperwork to form ABC Freelancer LLC, but hasn’t received confirmation of the filing yet. The paperwork was sent to the state by mail by overnight mail on June 1, so Ima assumes that the company will get organized effective June 2. Relying on that assumption, she signs a contract dated June 2, using ABC Freelancer LLC as her business name. Later she learns that a mail delay at the state capital pushed back the effective formation date of her business to June 3. From Ima’s perspective, it isn’t a difficult thing to document that ABC Freelancer LLC accepts the contract. The company’s organizing resolutions might specifically provide for that. But asking the client to re-date the contract would look bad, so Ima decides to let it stand. If something goes really wrong, meaning Ima and the client are in litigation and the client’s lawyers are carefully analyzing Ima’s records, the client might argue that because the LLC didn’t exist until the day after the contract was signed, the LLC couldn’t be a party to it, and Ima should be directly responsible for the company’s obligations. Even though Ima took steps to transfer her obligations to the LLC, that transfer doesn’t bind the client, who never agreed to it. Of course, in real life Ima would probably have good arguments to make, such as that the client has treated the LLC as though it was the contracting party, but the point is that she could have avoided needing to make those arguments in the first place by waiting for confirmation of her company’s formation before taking on obligations.
Personal Guarantees and Other Waivers of Limited Liability
Small business owners are often asked to waive their limited liability protections as part of making a deal, by agreeing to be personally responsible for their business’s obligations. A new company that is owned and operated by one person won’t have any credit history and probably won’t have significant assets that might serve as collateral. Businesses that enter into a risky arrangement with the freelancer, such as a lender, credit card company, or equipment retailer that sells on credit, may only agree to enter into a contract with the legal entity if the owner provides a personal guarantee that the company will pay what it owes. A properly documented personal guarantee stands alone as a contract between the owner, the business, and the outside business. If business goes badly and the company can’t pay its debts, the owner is on the hook to make up the difference. Although the business still also bears responsibility for the debt, the creditor need not bother with legal action against the business, and could take actions like placing a lien on the owner’s home or car.
Formal guarantees will usually be presented as written documents, and freelancers who encounter them probably will feel pressured to accept them as part of doing business. That is especially true for businesses that need to take out loans for equipment or startup expenses. The benefit of the deal may outweigh the risk, so the personal guarantee can’t be avoided.
Personal guarantees can also arise through verbal promises. A freelance photographer might say to a client, “I guarantee this will be the best photo shoot ever.” Just making that promise can put the photographer on the hook for the company’s obligations should something go wrong with the shoot, especially if the client has relied on the promise. If the photographer is shooting a wedding and only discovers after the ceremony that his camera’s memory card was bad, the client could justifiably demand that he pay the costs to re-enact the event, and (this is the important point) threaten to sue him personally to make good on his verbal promise. Getting into the habit of putting agreements in writing, and making sure that the agreements explicitly override any verbal promises, is a good way to avoid turning loose talk in your pitch into a personal obligation.
Protecting Yourself with Merger Clauses
A good contract should include a merger clause (or integration clause). A merger clause provides that the contract reflects the entire agreement between the business and the client, and explicitly replaces any written or oral agreements that might have preceded it. Such a clause protects everyone involved, by ensuring that the contract is the final word on the deal. Of course, a contract with a merger clause needs to be carefully drafted to ensure that it correctly reflects the deal both sides expect. And like many legal technicalities, merger clauses might not protect a business that makes false promises or otherwise acts unethically in making the agreement. Contract law in some states provides that written contracts automatically replace preceding discussions, but even in those states it’s a good idea to include it so everyone is clear about what is and isn’t in the contract from the start.
Accidental Assumption of Liability
The other way a business owner can assume personal liability for a business’s obligations is by not paying attention to formalities when making a deal. The client, subcontractor, or service provider needs to know that it is dealing with the company, not the freelancer in a personal capacity. A good way to do this is to have a written agreement that explicitly names the company as the responsible person. Even an informal agreement, such as an e-mail summary of the terms of a deal, can call a client’s attention to the identity of the “person” it is doing business with.
Making your company’s name a prominent part of your communications is a good practice. Your promotional materials—business cards, website, e-mail signature—should include the name of your company along with your name and title. If the client says something that makes you suspect that they don’t know they’ll be working with your company and not you personally, be sure to address the confusion.
All these steps are to avoid a mistake that is otherwise easy to make: accidentally accepting an agreement that binds you and not your company. A common way this can happen is if someone you’re doing business with presents you with a contract that doesn’t properly identify your company, and you agree to it without correcting the problem. Many companies have template contracts that they provide to contractors. Templates usually leave it up to the contractor to fill in their own details. Be sure to read these forms carefully and fill them in accurately, and don’t sign or agree to an agreement that puts your name on the signature line without including your company’s name. Chapter 8 goes into more detail about contracts.
Caroline Gets into Trouble
Caroline is a freelancing software engineer who owns Super Software LLC. Ordinarily, she handles all of her company’s business using a business e-mail address ([email protected]), and her e-mail software always includes a signature that prominently displays her company’s name and her role as the company’s president. Before doing work she always gets an agreement in writing, either using a form contract her lawyer prepared for her, or using the form a client provides. But one day she lets things slip. A close friend of hers approaches her about doing work for the friend’s personal injury lawyer, giving the lawyer Caroline’s personal e-mail address. Caroline agrees to do work for the lawyer and, thinking this is a friendly deal, casually agrees to the terms of a contract the lawyer sends over without first looking it over. Later on, a significant flaw in Caroline’s coding allows hackers to break into the lawyer’s systems and steal revealing information about the lawyer’s celebrity clients. As a consequence of the ensuing media outrage, the lawyer loses several clients. When the lawyer sues Caroline, she sends the case off to her company’s professional liability insurance carrier. But the carrier refuses to handle the case, arguing that the contract with the lawyer doesn’t belong to the company, so it isn’t covered by her insurance.
Losing Limited Liability through Litigation
Even if the business owner doesn’t personally assume the debts of the business, creditors can still try to go after the owner’s personal assets by arguing in court that the limited liability of the business’s legal entity should be ignored. Litigators call this piercing the corporate veil. Bear in mind that piercing the corporate veil is a litigation strategy, requiring the intervention of a court to be successful. It arises after someone has already successfully sued your business and is trying to collect.
Fortunately, courts don’t like to pierce the corporate veil. For one thing, the whole idea of limited liability is to encourage business owners to take risks. If a legal entity’s limited liability protections are easy to overcome, fewer people will take risks. Also, people are expected to know the risks of doing business with limited liability entities. Courts are reluctant to intervene to save someone from making a bad business decision.
Maintaining formal separateness between you and your business and not acting badly are the two most important steps for preserving the corporate veil. We looked at the steps to take to maintain corporate separateness in Chapter 2. Failing to take these steps can give rise to the idea that you have treated the business as your alter ego. The idea is that the owner has mingled her personal affairs with those of the business to the point that parsing them out isn’t feasible or fair. Freelancers who want to rely on a limited liability entity’s protections need to take this especially seriously, because businesses owned and operated by one person are more likely to fail the separateness test.
Avoiding acting wrongfully is the other important thing to do. “Wrongful” actions come in several flavors. The most straightforward are acts that are clearly unlawful, such as committing fraud or stealing. Another is acting in bad faith, by making promises that at the time you know can’t be kept. At least in theory, the social contract that grants business owners limited liability doesn’t allow owners to hide from responsibility for bad behavior. In practice, bad people can hire good lawyers and sometimes escape responsibility, but that’s an expensive, risky, and unethical road to tread.
The most common flavor of wrongful action is negligence, which can ensnare even scrupulous business owners. Negligence is a failure to exercise care that a reasonable person would take under similar circumstances, with someone else being harmed as a consequence.1 In a business setting, the measure of a “reasonable person” is probably a professional of similar experience as the business owner being sued, the idea being that the business owner hasn’t done something, or not done something, that would be expected of a generic professional in that line of work. For a freelancer who wants to reduce risks, this means being a smart and informed professional by staying aware of your field’s evolving best practices, and implementing them wherever possible.
Negligence has a broad scope. Much of the time, doing something negligent might not get you sued, but it will probably be embarrassing and damaging to your business. A copyeditor who accidentally deletes a citation from a scholarly article could expose her client to charges of plagiarism. A wedding photographer who mishandles a memory card and loses pictures of a ceremony will be lucky to escape with just forfeiting his fees for the shoot. The digital age has given rise to new sources of negligence. Misdirected e-mails, insecure cloud storage, and loose behavior on social media are just a few ways a freelancer can wind up in trouble.
Jim has earned a substantial sum of money from a contract that pays in installments, only he hasn’t been doing the work he promised to do. As he has been paid, he’s immediately transferred the funds from the company to himself as salary, and used them to pay off student loan debt. When the client discovers that Jim hasn’t been performing, it sues and wins. When it learns that Jim has taken the money it is owed, it argues that it should be able to reach past the Jim’s company to recover directly from his personal assets. In this example, Jim has acted badly, by knowingly accepting payment for services he wasn’t performing, so the fairness scales tip in the client’s favor.
Paula and the Prying Husband
Paula is a successful fiction editor who works from a home office for major publishing firms on high-profile novels. She has formed a limited liability company, Superstar Editorial LLC, to house her business and enter into contracts with publishers. Among the contracts are strict nondisclosure agreements, which threaten significant damages against Superstar Editorial LLC if it should breach its obligations. Paula keeps her client’s files on her computer, which does not require a password to access.
One afternoon, Paula tells her husband about an exciting new novel she is working on. The novel is by a famous author the husband enjoys. Later that evening while Paula is out at a freelancer association meeting, her husband accesses her computer and e-mails a copy of the new novel to himself and to his buddy, who also loves the author’s work. After too many glasses of wine the buddy posts a copy of the file to Facebook, where it is downloaded hundreds of times before he realizes his mistake. The publisher quickly discovers the leak and identifies Paula as the probable source. It successfully sues Superstar Editorial LLC to recover, among other things, $2 million in lost revenue that the publisher estimates the leak will cause. Paula figures she’ll have to put her business into bankruptcy, but at first she’s not worried about her personal assets. That is, until in the damages phase of the trial the publisher puts forward the argument that Paula’s LLC should be disregarded, and it should be allowed to recover its $2 million award from Paula personally.
From Paula’s perspective, there are lots of bad facts in this story. The two big mistakes Paula made were telling her husband about her project, which violated her nondisclosure obligations, and then not securing her client’s files, which the publisher will argue was negligent in light of the files’ substantial commercial value.
In the litigation, the publisher’s lawyers dug into Superstar Editorial LLC by asking for its minute books, bank records, and other evidence of its separateness from Paula’s personal life. Among other bad facts, they discovered that Paula had been cutting corners, using her company’s bank account to pay for her child’s daycare services and her monthly mortgage payments. In a business where the company’s assets can be reduced to a computer and a bank account, it’s starting to look like Paula is facing serious financial consequences.
The point of these above examples is to emphasize that just having a legal entity is not enough to protect yourself against personal loss. It is important to take other defensive steps, like protecting client files, respecting contractual obligations, and taking seriously your legal entity’s formalities. If you can afford it, buying professional liability insurance that includes coverage for litigation costs is another good way to limit risk, in part by offering litigators an alternative deep pocket to your own, one that will be defended by seasoned attorneys.
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1 Nolo. 2016. Nolo’s Free Dictionary of Law Terms and Legal Definitions. s.v. “negligence.” www.nolo.com/dictionary, (accessed December 9, 2016).