Let’s Limit The Liability, Shall We? (The Limited Principal).
The primary purpose of entity formation is to limit a business' liability (created by the business's employees and agents). It is legal armor created by law to promote business activity, and huge protection if adequately utilized. Businesses should take full advantage of this.
“Liability” is a term of art. Do not confuse liability with criminal liability, which is a distinct definition. Most, if not everyone, at some point in their lives, acts in a way that could cause damage to another individual.
For instance, a “slip in fall case” is a common act creating liability. A banana peel is dropped on the floor in a grocery store. A patron slips on that peel, falling and sustaining an injury. Whether the grocery store is liable (must pay for the patron's injuries) depends on whether or not the grocery store was negligent. And whether the grocery store was neglige
nt relies on a variety of factors; how long was the peel on the ground, was it in plain sight, was it a busy day; and so on. The point is it is irrelevant if the grocery store intended to hurt the patron (If they did, then criminal liability may then apply because it is a malicious act).
If a business is liable for an act, proper legal preparation will help limit the amount of damage a company sustains. Returning to the slip and fall example, imagine two scenarios:
In the first, assume the store is not operating under the protection of an entity. Instead, assume three individuals agreed to go into business with one another. Then imagine a court determines that the store is, in fact, liable. Under legal doctrines like “respondent superior” and similar law, all three partners are probably liable.
Now, if, on the other hand, the business is an entity, the entity will armor its owners, limiting the payment for liability from only the assets inside the company (because there is only one person, the entity).
Most businesses understand this concept. But filing the template entity formation documents is only scratching the surface of protection. Perhaps a business owner is operating more than one company. Or, maybe the business runs an active business and, at the same time, invests profits in real estate. In these situations, it is advisable to form separate entities for different business ventures, rather than running all the enterprises under a single entity.
These types of transactions are standard practice for big business. For instance, Walmart owns Sam's Club. Sam's Club is a separate business even though Walmart fully controls it. Or it is typical for companies to own a corporate “shell.” Businesses organize themselves in these webs to separate and protect assets, using entities to limit liability in different aspects of the business.
A small business owner should employ similar tactics. Understanding what entities to create and when to do so, should be discussed with the business owner's attorney. Additionally, there is a myriad of tax benefits when proper entities are utilized. Thus, in addition to an attorney, it is also highly advised to seek out advice from a CPA, which can consult with an attorney, forming a strong business team.
Please note: the contents found on this website are not legal advice and is strictly intended for educational purposes only. The legal needs of each individual vary significantly and are dependent on a variety of factors relevant to their specific needs. Please seek the assistance of an attorney for your legal advice.