Why LLCs do not Protect you from a Professional Liability claim

I attended the FREECON conference in Austin, Texas for freelancing professionals.  At the reception, I talked with a software engineer who had just left his job at a local large employer to strike out on his own to pursue his entrepreneurial dream.

He asked me why I was at the conference.  I told him that my partner and I had developed an online professional liability insurance solution for freelancers.  He responded “OK, why do I need a professional liability policy?” and one of the first things I said, he couldn’t believe!

I told him that if a claim is made against him for a professional liability loss, then he has personal liability for that claim, meaning his personal assets are at risk for satisfying that claim.  He said, “But I don’t have to worry about that because I have formed an LLC,” to which I responded “That won’t protect you from that sort of claim.”

A serious look of concern came over his face.  “But I have been careful to form an LLC so that I get the benefit of limited liability.  People have told me that any claim that arise against the business is limited to the assets that are in the LLC.  Is that not true?”

I told him it was true, to an extent.  Basically, in this context, it is helpful to distinguish between two types of liability that a business can incur.  The first is “contractual liability”, basically liability that arises out of contracts that you have with other people.  For example, if you get a loan from a bank for your business, and you default on that loan, then the bank can only go against the assets of the LLC to satisfy the bad debt.  (Incidentally, that is why almost every bank out there will also have you sign a personal guarantee which will allow them to go after your personal assets as well).

The second type is “tort liability”, or liability that is based on negligence.  If you commit an error that results in economic loss for your client, then the client can sue your LLC for their losses.  If the client only sued the LLC, then their recovery would be limited to the assets of the LLC.  However, in professional liability claims, the client will likely sue you individually as well.

When you think about it, an LLC really cannot commit a tort.  A person commits the negligent act.  Surely, the LLC has vicarious liability for the actions of its employees, but the LLC itself does not directly render services to clients.  Thus, in all professional liability claim scenarios, the injured client will sue the LLC and the owner/employee individually, and as a result that person’s personal assets are at risk.

The software engineer seemed convinced (and frankly a good bit scared!).  I told him that I was not at the conference to sell people insurance, but rather to educate people about the need for it.

The next day I ran into a marketing consultant who was asking me questions about professional liability insurance for her new venture.  Her services involved the marketing of consumer medical products, and she was justifiably concerned about the potential for claims against her.  But she also (incorrectly) thought that her LLC was going to protect her against any professional liability claims that could be made against her.

I told her “If that were true, then I suppose an LLC could just have $1,000 in its business bank account, and then if the owner commits numerous errors and omissions, the LLC owner says “OK, all of you clients can have your share of that $1,000, but I personally have no responsibility, because I have an LLC in place.”  Setting aside a separate legal analysis called “piercing the corporate veil” (which eliminates the benefits of limited liability for entities such as LLCs and corporations), this on its face does not seem legal or fair if the courts would allow this to happen.

Thus, if you are a professional rendering advice or service that could cause an economic loss to your clients, then you have exposure for a professional liability claim that can be satisfied out of your personal assets.  Many new entrepreneurs gladly spend much of their start-up capital to form the LLC to gain the benefit of limited liability.  As part of that process, entrepreneurs that render professional services should routinely also shop around to find high quality professional liability insurance to cover the exposure to the personal assets as well.