LLCs: How Limited is Your Liability?
Many real estate investors hold title to their investment properties through a limited liability company (LLC). While LLC rules vary by state, this structure protects real estate investors from personal liability beyond the member’s equity investment. An LLC’s administration is fairly uncomplicated, and it offers potential tax benefits. But be warned: Liability protection under an LLC isn’t unlimited, and the Tax Cuts and Jobs Act (TCJA) made both positive and negative changes to the tax rules that affect LLCs.
Beware of vicarious liability
An LLC won’t protect a member from liability for the member’s own negligent or otherwise wrongful acts that injure another person, 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 the member’s own name, rather than in the LLC’s name.
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 (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 its members. It could also happen if the LLC engages in reckless conduct or fraud or was inadequately capitalized from the beginning. In all these circumstances, a court might conclude that the LLC is merely a sham to shield its members from liability.
Watch out for loan breaches and defaults
LLC members who personally guarantee the company’s debts or obligations will be held liable for nonpayment or breach. This is a true risk when entering into contracts or financing agreements before the LLC legally comes into existence, where the other party insists on some guarantee.
To minimize the risk of personal liability, members should 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 completely understand the consequences of all potential covenant violations.
Remember the environment
Environmental liability is a common concern when purchasing property, and use of an LLC to make the purchase doesn’t negate that concern. The Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) imposes strict, joint and several 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. Thus, be sure to do thorough environmental due diligence.
Make an informed decision
The TCJA made some positive changes for LLCs, including lower tax rates and a new 20% deduction for qualifying pass-through entities. However, it also has some unfavorable changes, such as limits on deducting business losses and rules on deducting partnership charitable contributions and foreign taxes.
States also have strict rules regarding the termination of LLCs, whether intentionally or due to a member selling his or her portion of the business or the death of a member. So, consult with your attorney and tax consultant to determine whether an LLC is the right vehicle for your business.