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Beware of Tort Exceptions to Limited Liability

Filed under Asset Protection Strategies. Fact checked on May 24, 2012.

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Even if you operate as an LLC or corporation, you can be exposed to personal, unlimited liability if you personally take, or do not take, an action that causes injury to another. You also risk unlimited personal liability if you negligently hire or supervision your employees and another person is injured.

Every business owner should strive to limit liability for contracts and torts. As with the contract exceptions to limited liability, agency law is the key to understanding the exceptions to limited liability with respect to torts committed in the business.

As a brief definition, tort law is really personal injury law. The best example of a tort, perhaps, is negligence (i.e., carelessly causing injury to a person or damage to property.) When an individual commits a tort, he is legally liable to the aggrieved party. The aggrieved party can bring a lawsuit for monetary damages against the party who commits the tort. This is true even when the individual committing the tort is acting as an agent for a principal at the time he commits the tort. Simply put, the individual is always responsible for his or her actions, whether working or not.

Unfortunately, many individuals mistakenly believe that if they commit a tort while acting as an agent for a principal (e.g., while an employee is carrying out duties for the employer), they have no liability. This mistaken belief may arise for two reasons: insurance and the fact that the principal (the employer) also will be liable in this situation.

The employer, or more specifically the insurance policy carried by the employer, will pay off on the liability. However, the employee or agent has personal liability in this situation. The fact that the principal or employer has liability does not relieve the agent or employee from his or her personal liability. 

This is important to understand especially because there will not always be insurance that covers every situation or has sufficient face value to cover all of the damages involved. This is when the agent or employee is likely to be called on to pay the damages, discovering that the belief of no liability was mistaken.

Warning

The small business owner must remember that he will be acting as an agent or employee of his business entity. Therefore, the owner is doubly exposed to liability when committing a tort, because the entity and the owner personally are responsible. This is potentially a very damaging exception to your efforts to limit liability inside and outside of your business.

Torts committed within scope of employment. If an agent commits a tort while carrying out the principal's business (or "acting within the scope of the business" as some courts put it), the principal is automatically also liable for the agent's torts under a doctrine called respondeat superior, or the master-servant rule. This type of automatic liability, which is termed vicarious liability, also applies in other areas of law. It means that no wrongdoing by the principal at all needs to be proven.

The principal could have acted carefully and reasonably, but it makes no difference when it comes to defending against a lawsuit. When an agent commits a tort, the only real defense that may be offered by the principal is the argument that the agent was, in fact, not carrying out the principal's business at the time he committed the tort.

Example

John Jones, a purchasing agent for XYZ Materials, Inc., negligently hits a pedestrian while picking up a load of supplies in XYZ's truck. Both Jones and XYZ are liable.

Jones is personally liable because he committed the tort. XYZ is liable because Jones was acting as its agent at the time he committed the tort.

For the owner of the entity, three exceptions exist to limited liability for torts committed in the business. The owner will have unlimited, personal liability for torts when he or she:

  • personally commits a tort, which is especially possible in a personal service business;
  • is guilty of negligent hiring or supervision of employees; or
  • hires agents or employees, or sells goods, in his personal capacity, rather than as an agent of the LLC or corporation

Many times, all of these exceptions can be avoided. The last exception can be avoided in every case.

Work Smart

An employer also may be able to avoid liability for its agents or employees through the use of independent contractors.

Personal Actions Can Void Limited Liability

Under tort or personal injury law, if an individual personally commits a tort, that person is liable to the injured party. This is true regardless of whether the individual was acting as an agent for another party at the time he or she committed a tort. Of course, if the individual was acting as an agent, the principal (business) would automatically be liable as well.

Consistent with this general rule, if the small business owner commits a tort while acting as an agent for his LLC or corporation, the owner is liable to the injured party. The fact that his LLC or corporation also will be liable is not relevant to the owner's personal liability.

Many states codify this exception in their statutes governing professional corporations (PCs). All states incorporate this exception into their statutes that govern professionals (doctors, lawyers, architects, electricians, etc.) operating in the form of LLCs (or limited liability partnerships). Even when the provision is not statutory, however, the rule is universally applied by the courts, as a matter of common law.

However, this exception can be encountered even in a business that sells goods and provides no services, especially with a business that involves risk of injury to customers (e.g., operation of a lumber yard). An owner who personally stacks the store shelves or loads a customer's car in a careless manner will have personal liability for his negligence. An auto accident caused by the owner of the business represents another commonly encountered example of this exception that can occur in almost any business.

Warning

Operation of the business in the form of an LLC or corporation will not save the owner from unlimited, personal liability in this instance.

The exception to limited tort liability underscores why it is dangerous to rely on one asset protection strategy (e.g., formation of an LLC or corporation). Here, the owner will have to rely on other asset protection strategies, such as exemption planning, asset protection trusts, insurance, etc.

Negligent Hiring or Supervision Can Result in Personal Liability

A business owner may be personally liable when an agent of the business commits a tort, if the owner committed a separate tort, such as a separate act of negligence. Here, three parties are liable:

  • the agent or employee who commits the tort--because he or she committed it
  • the entity--under the doctrine of respondeat superior
  • the owner--for his or her own independent tort

Although there was only one action, two separate torts are committed: one by the employee and the second by the owner. Most likely, this independent tort will be in the form of negligent hiring or supervision of an employee of the entity.

This exception is really just a specific example of the first exception--namely, personal commission of a tort. Here, personal liability is predicated on the fact that the owner has personally committed a tort (i.e., the improper hiring or supervision of the employee) that is separate from, and in addition to, the tort committed by employee.

In addition, while this exception, too, is usually incorporated in state statutes governing professional corporations, LLCs and limited liability partnerships (LLPs) operated by professionals, it will apply in all states as a matter of common law and will apply to all businesses, not simply to those businesses providing professional services.

You can minimize this risk by taking measures to ensure that you act reasonably in hiring and supervising employees. Many strategies involve time, costs and philosophical questions related to employee's privacy. 

You must weigh these factors against the likelihood that the employee will commit a tort causing personal injury or property damage. This, in turn, will depend on the nature of the business and the employee's particular job.

In terms of hiring new employees, the small business owner may want to consider:

  • Background checks - including verification of prior employment, academic transcripts, licenses, professional affiliations, credit history, and arrest history
  • Drug testing - generally, state laws allow mandatory testing for all applicants, and then periodic random testing of employees, where the business involves safety risks

For example, a criminal background check is especially important in hiring employees at a day care center or in a business where the employees will handle large sums of cash. Drug testing would be appropriate in hiring bus drivers or where employees will operate machinery, such as construction equipment.

In terms of supervising employees, the small business owner may want to consider:

  • a mentoring process, whereby a new employee is instructed and supervised by a senior-level employee for a prescribed period
  • a system of checks and approvals before work is sent to clients, patients or customers
  • case/job tracking systems
  • regularly scheduled meetings where case/job status is discussed
  • training sessions (in-house or outside seminars) for employees
Example

Smith & Jones, LLC, a law office, hires a new attorney, Stevens, as an employee. Smith does all of the hiring for the firm. He interviews Stevens twice before hiring him. Smith makes sure that the LLC hires Stevens, so that the LLC, rather than Smith or Jones personally, will be the principal in any transactions initiated by Stevens.

Ten months later, Stevens commits an act of malpractice, costing a client $400,000 in losses. It is discovered that Stevens actually had dropped out of law school in his first year. This fact was never discovered by the firm, as Smith found him knowledgeable concerning the law during the two interviews and never conducted a background check.

It is likely that Smith will be sued personally for this loss due to negligent hiring. Had Smith conducted a proper background check, he would have avoided this liability. However, if the firm had instituted reasonable measures to conduct background checks and to train and supervise employees and these procedures were followed, Smith might have avoided personal liability.

Be Wary of Hiring or Selling in a Personal Capacity

A small business owner acts as an agent or employee for the LLC or corporation when selling goods or hiring agents or employees for the business. Acting in that capacity generally affords the owner personal liability protection for torts committed in the business. 

However, when the business owner forms a contract to sell goods in his own name or hires an employee or agent in his own name, he will have unlimited, personal liability for any resulting torts.

If you enter into contracts for the sale of goods in your own name, rather than as an agent of your LLC or corporation, you may be personally liable for injuries caused by the goods sold. If a consumer is injured by the product, the tort of strict liability may apply. 

Strict liability basically means that if you sold the product that caused the injury, you are liable. On the other hand, if the sales contract is in the name of the LLC or corporation only, then the seller is the entity, and the owner has limited liability.

Personally Signing Employment Contracts Creates Liability

Among the tort exceptions to limited liability for a small business owner is selling or hiring in a personal capacity. Doing this could negate carefully constructed asset protection plans.

To avoid this outcome, you must ensure that all business contracts are formed in the name of your LLC or corporation, and that you sign these contracts solely as an agent of the LLC or corporation. This is necessary if the owner is to escape personal liability for the contracts.

However, there is another reason to make sure employment contracts are properly executed as agent for the entity. If an employee is hired personally by the owner, then the owner and not the LLC or corporation will be the principal. In this case, if the employee commits a tort, then his principal (i.e., the owner personally) will have unlimited, personal liability, in accordance with the doctrine of respondeat superior.

This could result when there is a written employment agreement that has been improperly executed in the name of the individual owner, or where there is no written employment agreement and the owner pays the employee from a checking account in the owner's personal name. In both cases, the business owner will be the employer/principal.

Tip

The small business owner must avoid being deemed the personal employer/principal of employees. The LLC or corporation must be the employer. A written employment agreement is advisable in all cases. The agreement must clearly identify the employer as the LLC or corporation, and the owner must properly sign solely as an agent of the LLC or corporation.

The written agreement can be simple, specifying job description, rate of pay, and that the relationship is employment at will, for example, if that is desired. In employment at will, the employee may be terminated without providing a reason and without advance notice (and the employee may quit without giving a reason or any advance notice).

A written agreement also can be used to specify that the worker has been hired as an independent contractor.

An informal relationship with employees (i.e., where no written employment agreements exist) can still be used, but this offers less protection. In this case, paychecks in the name of the LLC or corporation only can be used to establish that the LLC or corporation is the employer.

Case Study Tort Liability in an LLC

Smith, Jones, and White are all physicians and operate a medical practice, which is organized as a limited liability company (LLC).

Smith commits malpractice. Smith has unlimited, personal liability for this tort because he committed it. The LLC also has unlimited, personal liability automatically because of the respondeat superior doctrine.

The other two co-owners, Jones and White, have limited liability. The most they can lose is what they have invested, at the time, in the LLC. They have no personal liability for this tort.

The practice (specifically the LLC) hires another physician who is not a partner in the business. This doctor commits an act of malpractice. Assuming there has not been an independent act of negligence by one of the partners (such as negligent hiring or supervision), the employee-physician will have personal liability because he committed the tort and the LLC will have personal liability under the respondeat superior doctrine. All three owners will have only limited liability, and no personal liability, for this tort.

However, if it can be proven that the three co-owners were negligent in failing to properly train and supervise this employee, the three co-owners will have unlimited, personally liability for their tort and, effectively, for the employee's tort.

Technically, the three co-owners are not liable because of the act of malpractice committed by this employee. Nor are they liable because of the doctrine of respondeat superior. They are liable for their own independent act of negligence. This is consistent with the general rule that an individual is liable when he personally commits a tort.

The same result would occur if the three co-owners were negligent in hiring the employee. This could happen, for example, where the owners failed to conduct a background check to verify the employee's credentials, arrest records, credit rating, work history, etc., and one or more of these failings were a factor in the employee's malpractice.

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