During the last decade, limited liability companies ("LLCs") have become one of the most preferred forms of business entities through which to hold title to investment real estate properties. Prior to LLCs, real estate investors seeking limited liability protection were largely limited to using corporations to acquire title — a form of entity that has potential drawbacks.
All 50 states have enacted legislation creating some form of the LLC business structure, although the rules vary from state to state. The insulation from personal risk exposure for real estate investors provided by LLCs, coupled with the relative ease of administration and potential tax benefits, makes ownership of investment property through an LLC a desirable option in most instances. In general, an LLC member’s personal liability is limited to his or her equity investment. But investors should be aware that there are some limits to the liability protections afforded by LLCs.
Environmental liability is a common concern when purchasing property, and use of an LLC to make the purchase doesn’t make that concern moot. The Comprehensive Environmental Response, Compensation, and Liability Act ("CERCLA") imposes strict, joint and severe liabilities — no showing of negligence or intent is required — for cleanup costs on past and present owners and operators of facilities where hazardous materials have been released. An LLC member who had the authority to control the operations or decisions involving the disposal of hazardous substances could be held liable for cleanup.
Loan breaches and defaults
LLC members who personally guarantee the company’s debts or obligations will be held liable for their nonpayment or breach. This is a true risk when entering contracts or financing agreements before the LLC legally comes into existence, because the other party insists on some guarantee.
To minimize the risk of personal liability, always act in the name of the LLC. When you sign contracts, for example, do so solely as an agent of the LLC, making sure to identify the LLC as the principal in the document. Similarly, make sure that the LLC’s other agents and employees act as representatives of the entity, and not of you personally. For extra protection, members might consider adding a personal umbrella policy to the LLC’s traditional business insurance coverage.
Certain loan defaults may also create personal liability. Carefully review all loan documents to make sure you completely understand the consequences of all potential covenant violations.
An LLC won’t protect a member from liability for his or her own negligent or otherwise wrongful acts that cause injury to another, such as assault or fraud. That could include negligent hiring or supervision of employees if an employee causes some type of injury, and the member hired the employee in his or her own name, rather than in the name of the LLC.
Also note that, if an LLC member commits a wrongful act that causes injury while acting as an agent or employee of the LLC, it’s not just the member’s personal assets that could be targeted by the injured victim. The victim could also go after the assets of the LLC, under a theory of vicarious liability (also known as “respondeat superior liability”) for its agent’s acts.
On rare occasions, a court will “pierce the corporate veil” to impose liability for an LLC’s debts and obligations on its members. This typically occurs when closely held and small businesses fail to observe corporate formalities such as holding regular board meetings, keeping minutes, adopting bylaws, and ensuring company finances are separate from those of members. It could also happen if the LLC engaged in reckless conduct or fraud or was inadequately capitalized from the beginning. In all of these circumstances, a court might conclude that the LLC is merely a sham to shield its members from liability.
Go on the defenseA disadvantage of operating an LLC is that the company may automatically end if a member of the company decides to sell his or her portion of the business, or if a member abruptly passes away. In this scenario, the LLC may legally be required to terminate its affairs, pay creditors, file dissolution documents with the LLC’s state of formation, and distribute the company’s remaining assets to the LLC members. Get in touch with one of our tax advisors to ensure you’re covered.
Seek the services of a legal or tax adviser before implementing any ideas contained in this blog.