Why a Corporate Liability Shield Is Not a Replacement for Liability Insurance
Business owners who form a corporation or a limited liability company (LLC) may question the need for the business to carry insurance. A major benefit of these forms of business organization is that they shield the owners’ personal assets. Because of this, they may believe insurance is unnecessary.
A corporation is a legal entity separate from its owners. It acts as an artificial legal person. It can do the things that individuals may do, such as:
- Enter into contracts
- Incur debts
- Earn income
- Make investments
- Sue others, and be the target of lawsuits.
It gives its owners a legal shield against many of its obligations. In other words, an individual owner of a corporation (called a “stockholder”) does not have to pay for the business’s debts out of his or her own funds.
An LLC also shields its owners (known as “members”). However, tax laws apply differently to LLCs than they do to corporations. If a corporation earns $10,000 in income, it must pay tax on that $10,000. If an LLC earns $10,000, the money is distributed to the members and they individually pay taxes on it.
Corporations and LLCs shield their owners and members from liability for the entity’s debts.
Suppose someone sues the business, claiming that its product injured them. A court orders the business to pay the injured individual $1,000,000. The business must pay that amount out of its assets. But, the individual owners or members do not have to cash in their bank accounts or homes to pay it. The most they stand to lose is the amounts of their investments in the business.
Legal shield only goes so far
The shield is not absolute. A court may hold individual stockholders and members liable in some situations. If they personally and directly injure someone, the shield does not protect them.
The court may also decide that the corporation is a sham entity. It could do this if the business has not conducted the normal activities of a corporation, such as:
- Holding regular stockholder meetings.
- Keeping business records separate from those of the owners.
- Investing adequate capital in the business.
Regardless of the shield, the business should carry insurance. The shield cannot protect the time and effort that goes into building a business. An uninsured accident can wipe out all of the business’s assets. Without large additional investments, it might not survive. The stockholders’ investments in money, time and work will have been wasted.
Also, an individual acting on the business’s behalf may incur personal liability. For example, while driving on company business, a member may injure someone in a car accident. Business liability and auto insurance policies usually insure individual stockholders and members for acts they perform in their roles with the business. Without this coverage, the individual would have to hire their own lawyers and pay judgments out of pocket.
For these reasons, wise business owners buy insurance. They should insure the business’s buildings, property, and liability risks. The personal liability shield is no substitute for insurance protection.