Creating an LLC for your business isn’t always as cut and dried as many may think. I often talk to really small business owners who probably could have saved some money by not forming an LLC and stayed with the tried and true sole proprietorship option that has worked well for many generations of business owners.
Today we’ll discuss if you should have an LLC or not from an insurance and liability perspective.
I almost exclusively work in the world of commercial business insurance and often have new or soon to be new business owners asking about how to best protect their assets and of course shifting / transferring liability exposure and risk to an insurance company.
For those businesses that haven’t done so, setting up the business entity type is an area of discussion that rarely fails to come up. In many business industries, the liability pros and cons of operating as a separate entity are much different than what many businesspeople imagine or have “heard” from friends and others who may have very limited knowledge, or often, incorrect knowledge.
I also see online postings and get asked the question of if it’s better to form an LLC or buy insurance. As you would expect to hear from an insurance agent and broker, buying insurance is the correct answer in 99.99% of the time, albeit the reasons why will surprise you.
Let’s start with case scenarios where forming an LLC makes little or no sense at all.
In our first business, the owner rents an apartment, unmarried, and has little or no assets. They also expect to make about $1000 or less profit in their first year. Their age can make a difference, albeit for the sake of argument, we’ll say they’re at or nearing their 60s.
This person is also starting a business where they will have no employees, and they will not be taking on any debt. And actually, the debt part doesn’t really change things much because any debt incurred, will most likely require a personal guarantee, however, for simplification, there’s no debt.
And to make this situation easy to imagine, let’s say the person is going to paint interiors of homes for “extra spending cash.”
Why shouldn’t this person form an LLC?
The first reason is the cost. The costs can vary largely depending on the state the business owner is in, however, it’s safe to assume the first year filing and consulting with a professional is going to cost at least $200 or more. Even if the business person uses the standard default state settings on the state’s website for forming a vanilla LLC, it’s unlikely the cost will be less than $150, at least for the first year.
The only real advantage for this person in forming an LLC is the hope the business name having LLC after it will create greater credibility and trustworthiness because the owner went through the time, energy, and expense of forming a separate entity. This is an advantage that’s difficult to quantify, even for the owner, so we’ll just say it’s a possible advantage knowing it may not have a material impact for the business.
Another advantage is the insurance cost. Yes, a LLC often will pay slightly less for the exact same coverage as a sole proprietor will. I don’t actually know why based on a carrier informing me, however I do have what makes logical sense to me why the rates will be less.
I believe a sole proprietor may open the door to non-primary business activity liability exposure. For example, let’s say our painter helps a neighbor cut the grass and while cutting the grass, the lawnmower causes damage to the air conditioning unit or something else near the home.
The homeowner gets mad and demands payment for the damage. The insurance company will likely have to at least defend the claim, and potentially have to pay out. Again, it really depends on the state, with many states taking the position that any activity is covered, while others allow the stated scope of operations dictate if coverage is required by the insurance carrier.
From a tax perspective, a LLC electing to be taxed as a sole proprietor will have the same tax exposure as a sole proprietor. Even if the LLC takes a C or S corp tax treatment election, the additional accounting costs and time will likely totally offset the desirability from a financial point of view.
Because the painter isn’t going to incur debt, and any debt incurred is assumed to require a personal guarantee, the LLC offers little or no creditor protection.
Furthermore, as the person performing the work, if the painter breaks something, vicarious liability while simultaneously transferring complete liability to the employer won’t work in any state I’m aware of.
What I mean by vicarious liability is as an employer, you’re responsible for the actions of your employees when they’re acting within (or close to within) the scope of their employment, often even when they break company rules and/or the law.
If our painting business owner expands and hires a painter to work for him, the business owner may have an employee manual that states within that while driving to and from a job site, the employee is to obey all traffic rules and laws.
Even if the employee breaks a law, such as not stopping for a red light and this in turn causes an accident, the employer is almost certainly going to be held responsible for the employee’s actions. In some cases, the employee may not have liability at all.
Or if so, secondary to the employer’s liability due to a legal concept called vicarious liability, which varies from state to state, so you’re well advised to seek professional legal advice for your state if you’re an employer and want to learn more.
It doesn’t matter than the employee was in technical violation of both state law and the company’s rules, the employer has liability exposure. Now, depending on the action by the employee, the employer may or may not have exposure, but a LLC employer may shield the LLC owner from exposure in this scenario.
Because a business owners general liability policy is going to provide a legal defense regardless if the entity is a LLC or sole proprietor, and that’s almost certainly the greatest obstacle for a plaintiff to get at the business owner’s assets, the LLC isn’t really helping. In other words, the benefits desired from an LLC are mooted due to other factors and the business owner can maybe save some time and money staying small and having a sole proprietorship instead of an LLC.
And for clarity sake, in my mind within the context here, a LLC is the same as a corporation. They’re two very different types of entities, albeit I’m looking at this from an insurance liability point of view. Other considerations may impact your consideration between a corporation and LLC. Again, talk to a professional legal advisor if you want to know the pros and cons in your particular scenario.
Again, as the person who physically “causes an injury” (regardless if bodily or property), you shouldn’t anticipate having an LLC entity providing protection, because you’re the one who caused the injury.
Therefore, in within this fact pattern, jumping through the hoops to create an LLC will not likely bear fruit.
Another similar situation is when the owner is also a driver of a vehicle. Let’s use non-emergency medical transportation as an example because I have client businesses that are NEMT providers.
While a LLC entity may provide liability protection for NEMT operators hiring employee drivers, as a one-man or one-woman band, you’re physically driving the vehicle and therefore you should expect any claims and/or lawsuits to name you directly.
And in terms of who gets named, and going full circle to the question of is it better to form a LLC or buy insurance, I’ll have you answer this question for me, so you can follow the fact pattern why in 99.9% of the time, forming a LLC is worthless for liability exposure if you don’t have insurance (making insurance the right choice).
For this we’ll use the painter business again, only so we don’t have to use driving and the required by law influence of insurance. Let’s say the business owner negligently leaves a ladder up and open while leaving for lunch. In the meantime, a small child decides, as anyone with small children know will happen, decides to climb the ladder.
While climbing the ladder, which in this situation we’ll add is next to the stairs leading lower, the child slips and falls about 15 feet, breaking several bones and requiring a trip and stay at the hospital
You can bet the plaintiff’s attorney will not only name your LLC, albeit will also name you personally. And because you thought you would spend your money on forming an LLC because it would last your lifetime, instead of spending money for business general liability insurance, which has to be renewed every year, you don’t have insurance.
When the plaintiff names you and your LLC, you may feel and even say “here’s the keys to the storage unit with all the painting gear,” thinking you’re fine because the LLC will limit your personal liability.
However, there’s that pesky fact of you also being named. You think to yourself that you have renters or homeowner’s insurance and there’s liability coverage afforded from that. However, your homeowner’s agent quickly says “sorry, your personal liability coverage excludes all business activities, so you don’t have coverage.”
Now what? You must defend yourself, which may mean stroking a large check to pay an attorney to defend you against the lawsuit. It also means if you have assets that aren’t excluded from judgments (often retirement money can’t be touched for example), you’re on the hook.
An expensive insurance policy for $700 may save you from losing $300,000 in this type of situation. This is especially relevant if you have rental property or other valuable assets you can’t keep from creditors.
Even a false, or unjustified lawsuit could cost you thousands of dollars in legal fees to defend, which you can’t expect, much less count on, having returned to you from a losing plaintiff. In United States, for the most part, each side pays all or most of their own legal costs regardless of what side wins.
In a nutshell, if you don’t have any assets, won’t have assets, and won’t have employees or much in terms of income (thinking less than $5,000 a year), you can likely just get an insurance policy and forego the time, money, and work involved with setting up an LLC, because it’s unlikely you will get any real worthwhile relative benefit from having one.
Next, let’s look at scenarios where I think having a separate entity is a must for a new startup business.