Many, if not most, businesses are organized in a way that increases their lawsuit exposure despite using corporations and partnerships to give limited liability.
There are a number of areas that must be reviewed regularly: what form was used for the business, what is the relationship between the owners, what is the potential exit strategy, and where are the assets and liabilities located in the overall business structure, among other things.
Business can be sole proprietorships, corporations or limited liability companies, or partnerships that can be general or limited. Structuring is a very complicated area and I have a white paper that compares the various forms which can be obtained by emailing me.
For what we are talking about, though, you can think of the sole proprietorship as being an individual doing business with the maximum liability which is almost exactly the same maximum liability as a general partnership. You are as exposed as you can get if you are using those. I would not recommend sticking your neck out like that.
The classic way lawyers limit liability for their clients is to pick a form of structure that the law makes limited exposure. The stockholders of a corporation are not personally liable for corporation debts and acts normally. The members of a limited liability corporation have similar limited liability. The limited partners are not liable normally for limited partnership debts and liabilities but the general partner is fully liable. Thus, the general partner is usually a shell corporation or what I call “an empty basket”. If sued, there are no eggs in the basket for the foxy trial lawyer to get.
Let me give you an example that should just scare the devil out of some owners. It is a real example but the names and facts have been changed just a bit to protect confidences.
One morning, an hourly truck driver hooks up his tractor trailer rig and drives out of the truck yard. In the course of driving on the highway, he or she will pass you and me in our cars on the way to work. The truck will also pass school buses, vans, and regular buses in the course of the day. While truck drivers are trained professionals, they are also hourly employees and like all of us, they can have momentary distractions. They are also operating machinery that just flat cannot stop on a dime–so even if they are doing everything perfect, someone else’s actions can put the truck in a precarious position.
On this particular morning, while going 60 miles an hour, which was actually below the speed limit, a car swerves in and out of traffic from behind the truck. When the swerving car reaches the truck, he cuts in front of the truck which slams on its breaks. The swerving car keeps on merrily down the road, but the truck is caught in its own circumstances. The driver fights the vehicle but loses control. The van swerves into a bus, which leaves the roadway. In the crash that follows, four other cars are involved including a small compact, which is carrying the owner of a business to work. To keep the story short, there are two deaths, including the business owner, and two people who are critically injured.
Fast forward two years later. The trucking company has been sued along with the driver. The driver, of course, has no assets of his own. The trucking company, while technically not “at fault” is not likely to fare well if the case is tried at the courthouse. The trial lawyer representing the business owner is demanding over a million dollars alone just for the death of the business owner and there are other people who have large claims.
The trucking company is owned by a responsible family that had purchased not only the minimum insurance required by law but also increased limits. Nevertheless, the severity of this accident is resulting in damages that will exceed the limits of their insurance policy.
Let’s talk about what that means for a second.
If the total damages are $4,000,000 as claimed and the insurance policy allows $2,000,000 in total coverage for the accident, then there is potentially $2,000,000 for which the trucking company owners do not have insurance.
Well, the owners themselves do not have to worry because they have limited liability. They normally cannot be held personally liable for more money. Their investment in the company is totally at risk but not their other assets. The company itself, though, is fully liable for the whole $2,000,000 that is uninsured.
To make matters worse, the insurance company provides the defense to the lawsuit. In this situation, the insurance company does its duty but decides that it is best to pay or tender the policy limits of $2,000,000 into the registry of the court. The issue then is not whether it is owed but which plaintiff gets how much.
But that action can be devastating for the trucking company because when the money is tendered, the duty to defend is over. The trucking company then has to hire its own lawyer to defend against the amount that is uninsured. Furthermore, the trucking company may end up having to write a check for the damages over the $2,000,000 already “paid” by the insurance company. Not a good situation for the trucking company or its stockholder owners.
So the trucking company owner turns to his corporate lawyer and says, I thought we had limited liability? The lawyer replies you do but the company is fully liable for the acts of the truck and the driver. Pressing further, the owner says but we can’t write a check for that, we’ll be out of business. The lawyer just shrugs.
What went wrong? The company has a full basket. Its eggs are all in one basket. The company is not a shell. It owns real estate. It has cash in the bank. It owns other businesses. The operating company had all the eggs. Your operating company should never own anything. Bad planning.
A structure like that is probably also structured to maximize its tax liability. It is the hardest structure to be able to lower tax brackets because there is only one level. Further, getting profits out of the company to the shareholders can be difficult. Perhaps just as critical, a lender would not offer the largest available loans or the best rates because of exactly what we described above, maximum liability.
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