A real risk

Obviously, you want to avoid personal liability when conducting your business. But in some circumstances, accepting a risk of personal liability is necessary to operate or grow your business. For instance, if you want to compete for government contracts or contract with an owner or general contractor who requires construction bonds, you may decide the benefits of obtaining such contracts justifies the risk of personal liability.

Bonding companies invariably will request personal guarantees from you (and perhaps your spouse) in the general agreement of indemnity before issuing a bid, performance or payment bond. To obtain bonding, you may have to agree to sign the general agreement of indemnity personally and as a company representative. In these situations, be well aware of the personal liability exposure if there is a bond claim and the surety makes a payment or a supplier is not fully paid.

In contrast to a situation where you knowingly accept potential personal liability, you may unintentionally expose yourself to personal liability based on how you operate your company and conduct yourself. To avoid this, be certain to treat your company as a separate legal entity, satisfy the applicable business law requirements and conduct yourself in such a manner so there would be no justification to find you personally negligent in the operation of your business.

Piercing the corporate veil

Contractors historically have set up their companies as corporations to avoid the risk of personal liability. To reduce tax liability and still maintain the corporate shield, many contractors have structured their companies under Subchapter S of the Internal Revenue Code to avoid paying corporate and personal taxes on dividends by having all profits passed along to and taxes paid by individual shareholders.

Another option—the limited liability company (LLC)—has become a popular form of legal entity for contractors to conduct business. With less stringent requirements and more flexibility than a corporation, an LLC still shields against personal liability and, similar to a Subchapter S or partnership, can be used to avoid paying corporate and personal income taxes on a company's profits. Corporations and LLCs serve as personal liability shields because they are legal entities, separate and distinct from their individual owners, officers, shareholders, managers and members.

As long as you properly set up the corporation or LLC, satisfy the relatively minimal registration and record-keeping requirements on an ongoing basis and, most important, treat and operate the corporation or LLC as a separate entity, company owners will have the benefit of the personal liability shield.

Making sure the corporation's annual registration is filed with the applicable state officials and that the corporation remains in good standing is a step you should take each year. Similarly, the corporate minutes book, including a record of at least the annual meetings of the board of directors and share-holders, should be updated annually and updated if previous years' minutes are missing.

If owners fail to treat a company as a separate legal entity, intermingle company and personal assets or do not clearly distinguish between company and personal transactions, a lawsuit seeking to make owners personally liable is likely to be successful at piercing the corporate veil. If a court deems a corporation or LLC to be nothing more than the "alter ego" of the owners who treat the company as an extension of themselves, the corporate shield will be shattered and the owners will face personal liability.

An example

In May 2008, AACON Contracting LLC, Bridgewater, N.J., entered into a $394,000 subcontract with Poppe Construction Inc., Franklin Lakes, N.J., to perform concrete and masonry work in the construction of a new Walgreens store. In the subcontract, Poppe Construction represented it was the general contractor that had entered into a contract with Walgreens. But another legal entity, Poppe Contracting Inc., Franklin Lakes, N.J., actually was the general contractor, and progress payments were made to AACON Contracting with checks issued by a third entity, Walter H. Poppe General Contractors Inc., Franklin Lakes, N.J.

Glenn Poppe was the sole owner, shareholder and officer of all three companies. None of the companies had employees or equipment. Glenn Poppe reviewed all contracts entered into by the three entities, and he received wages from Walter H. Poppe General Contractors.

After resolution of a dispute involving the quality of a portion of AACON Contracting's work, Poppe Construction owed AACON Contracting $156,704. When no payment was made, AACON Contracting filed suit in New Jersey against Glenn Poppe personally and each of the three Poppe entities alleging fraud, negligence, breach of fiduciary obligation and conspiracy to commit fraud.

In AACON Contracting's suit, its president stated that when he executed the subcontract with Poppe Construction, he relied on representations made by the entity that had a contract with Walgreens. He certified Poppe Contracting and Glenn Poppe represented to AACON Contracting that AACON Contracting was not being paid because Poppe Construction had not been paid by Walgreens for AACON Contracting's work. He also said AACON Contracting relied on misrepresentations of the Poppe entities that payment would be forthcoming when AACON Contracting agreed to return to complete punch list work. Evidence showed Walgreens paid Walter H. Poppe General Contractors and payments made by Walgreens were the result of applications submitted by Poppe Contracting reflecting Poppe Contracting had paid AACON Contracting.

Glenn Poppe contended he did not have personal liability to pay the corporate debt owed to AACON Contracting. The trial court judge found AACON Contracting sustained damages as a result of the defendants' false representations; AACON Contracting successfully pierced the corporate veil of the Poppe entities; and Glenn Poppe was personally liable. The trial court judge pointed out:

• At the time of performance of the contract, Glenn Poppe was the sole shareholder, officer and director of all Poppe entities.
• Glenn Poppe was clearly and solely responsible for the actions of all three entities.
• The three Poppe corporations had no employees during the time the contract was entered into with AACON Contracting and currently had no employees.
• Glenn Poppe reviewed all contracts for each entity.
• Glenn Poppe was the sole individual responsible for shuffling the corporations to achieve a purpose, namely the avoidance of obligations to AACON Contracting.
• All three companies were exclusively controlled by Glenn Poppe, who used the entities to avoid paying AACON Contracting.

Poppe appealed the trial court's decision to the Superior Court of New Jersey, Appellate Division. In its July 2012 decision, the appellate court affirmed the trial court's decision. The appellate court ruled there were sufficient grounds for the trial court judge to pierce the corporate veil and find the defendants jointly and severally liable. Even if the three Poppe legal entities did not have sufficient assets to make payment, AACON Contracting would be able to obtain payment of the contract balance from Poppe's personal assets.

Personal tort liability

Piercing the corporate veil is not the only route for a plaintiff who claims to have sustained personal injuries or property damage because of a corporation's or LLC's conduct.

Many contracting firm owners have a false sense of comfort that as long as they comply with the legal requirements for corporations and LLCs, they do not face a risk of personal liability for the conduct of their companies. However, a growing number of court cases in recent years, particularly involving suits against members of LLCs, have concluded individual owners, officers and members of corporations and LLCs can be held personally liable for their allegedly negligent acts or omissions when operating their businesses.

The law is well-established in most states that there is personal liability for company officials who engage in "tortious," or negligent, conduct. This principle often is referred to as the "tortious conduct exception" to the general rule of limited liability.

If an individual is found to have acted in a wrongful manner that courts classify as a tort, there may be personal liability. For example, driving through a red light or in excess of the speed limit and causing injury to another person is a common tort. Although obviously there is no contract between the two parties, the offending driver is liable to the other party for his or her wrongful conduct.

The tortious conduct exception does not apply to claims alleging a breach of contract. Unless the individual owner, officer or LLC member personally makes a contractual commitment, such as making or signing a personal guarantee, the liability shield created by doing business as a corporation or LLC will insulate him or her from personal liability based on an alleged breach of contract.

In the 2007 New York case Panusuk v. Viola Park Realty, LLC, a homeowner, dissatisfied with the quality of the home built by and purchased from the homebuilder, filed suit against the LLC and its member,

Kenneth Bergstol. The complaint alleged Viola Park Realty, New City, N.Y., and Bergstol breached their contractual and warranty obligations, failed to construct the home in a skillful manner, and were negligent and careless in their design and construction of the home.

The New York Supreme Court, Appellate Division, stated the two claims asserted against Bergstol were "sound in breach of contract, not negligence" and Bergstol could not be held personally liable because "a member of a limited liability company may not be held personally liable on contracts entered into by his or her company, provided he or she did not purport to bind himself or herself individually under such contracts." The plaintiffs apparently did not present any evidence that supported a claim for personal liability.

In a construction context, when a contractor's negligence results in injury to a third party, the injured person can and undoubtedly will pursue a tort claim against the contractor. Because an injured bystander will have had no contract with the contractor, a tort suit will be brought. As a result of the tortious conduct exception, the suit might include individual owners if there was some evidence of personal negligence and the plaintiff was concerned the contracting company lacked adequate financial resources or insurance.

The tortious conduct exception to limited liability is based on an individual defendant having personally acted negligently or committed a tort. In a suit between a contractor and building owner alleging only a breach of contract, the tortious conduct exception will not apply. Unfortunately, many states allow a tort claim to be brought for allegedly negligent construction in addition to a suit for breach of contract. The existence of a tort claim opens the door to potential personal liability.

If an alleged injury is for an economic loss because the plaintiff did not receive the benefit for which it contracted, the defendant may be able to obtain a dismissal of the claim based on a principle known as the economic loss rule. Depending on how state law views the economic loss rule, a claim in which the plaintiff seeks recovery of only an economic loss can only be brought as a breach of contract. But if a suit alleges personal injury or property damage other than repair of allegedly defective work, the economic loss rule is not likely to apply and a tort case can be maintained.

Personal tort liability applies to acts and omissions committed by individuals even though the acts may have occurred during the course of conducting business for a corporation or LLC. The critical distinction (though sometimes the line can be blurred) is between tortious conduct committed by the individual for which there is personal liability and tortious conduct by the corporation or LLC in which case officers, owners, shareholders, members and managers are not liable as a result of their status in the corporation or LLC. The distinction can be cloudy when allegations are made that an individual participated in the tortious activity or participated in the decision that led to the wrongful act causing injury to the plaintiff.

One more case

In the April 2012 case 16 Jade Street, LLC v. R. Design Construction Co., LLC, the South Carolina Supreme Court joined a majority of state courts that have held an individual member of an LLC can be held personally liable for negligence in the performance of a construction contract entered into by the LLC.

Carl R. Aten Jr. and his wife were the only members of a home construction business known as R. Design Construction Co. LLC, Bluffton, S.C. R. Design Construction entered into a contract to construct a condominium building with 16 Jade Street LLC, Ladys Island, S.C. R. Design Construction brought in a subcontractor to perform framing and block construction, which was negligently performed. After the subcontractor left the job, R. Design Construction, as the general contractor, did not adequately address the defects or replace the subcontractor. R. Design Construction was replaced with a new general contractor, and more defects were discovered. Subsequently, 16 Jade Street sued R. Design Construction, Aten personally, the subcontractor (a corporation) and the subcontractor's principal for negligence and breach of warranty; Aten and R. Design Construction also were sued for breach of contract.

The trial court ruled against R. Design Construction for breach of contract, negligence and breach of implied warranties and against Aten personally for negligence. The trial court also found against the subcontractor corporation for negligence and breach of contract. The trial court ruled Aten was personally liable on the grounds that he held a residential homebuilder's license individually and the applicable statutes created personal civil liability for the licensee. The court awarded damages in excess of $925,000.

On appeal, the issue was whether Aten was personally liable for negligent acts he committed while working for an LLC of which he was a member. The starting point was an examination of the applicable provision in the South Carolina LLC statute, which is based on the Uniform Limited Liability Company Act and virtually identical to limited liability statutes in other states.

The applicable statutory language provides that "the debts, obligations, and liabilities of a limited liability company, whether arising in contract, tort, or otherwise, are solely the debts, obligations, and liabilities of the company" and "a member or manager is not personally liable for a debt, obligation, or liability of the company solely by reason of being or acting as a member or manager."

The court then framed the question as follows: Did the South Carolina legislature intend to "generally shield members from personal liability for acts they commit in furtherance of the company's business"?

The South Carolina Supreme Court noted a majority of states examining similar statutory language have concluded a member of an LLC is always liable for his or her torts and cannot rely on status as a member of an LLC for protection.

The court acknowledged the statutory language could be read to shield a member from personal liability but declined to make that interpretation. Because "the right to sue one's tortfeasor is a longstanding right in our legal system," the court said it would not abrogate the right to bring tort claims unless the statutory language clearly showed that was the legislative intent, which the court did not find here. The court emphasized shareholders and officers of corporations have long been personally liable for their own acts or conduct though they are not liable for the acts or debts of the corporation.

The South Carolina Supreme Court readily acknowledged LLC members would not be liable for the LLC's wrongful acts simply as a result of being a member of the LLC. Accordingly, Aten's wife, who was the other member of R. Design Construction, would not have any personal liability exposure because she was not personally involved in any of the alleged negligence. But Aten was held personally liable because he was found to have been personally negligent in supervising the construction and ensuring the work was properly performed.

The South Carolina Supreme Court recognized courts in Illinois, Kentucky, Louisiana and Wisconsin have concluded their states' LLC statutes shield a member from personal liability for at least some tortious conduct.

Contrary to the Uniform Limited Liability Company Act, the Florida LLC statute exempts members from ordinary tort liability. The Florida statutes governing corporations and LLCs include provisions stating corporate directors and LLC managers and managing members are not liable to third parties except in the case of "recklessness or an act or omission which was committed in bad faith or with malicious purpose or in a manner exhibiting wanton and willful disregard of human rights, safety, or property." So the risk of personal tort liability of a construction company owner in Florida is much less than that faced by a contractor operating in California, Connecticut, Delaware, Georgia, Indiana, Iowa, Maryland, Michigan, New York, North Carolina, Oregon, South Carolina or other states that take the same approach.

Proper conduct

As long as you operate your business in a manner that does not abuse the corporate form, a suit seeking to pierce the corporate veil will not be successful. However, there may be personal tort liability if there is evidence establishing individual owners, officers or members personally acted negligently or participated in a decision or activity that was considered or led to tortious conduct.

To avoid company and personal liability, double your efforts to promote and enforce policies and procedures to ensure good safety practices are followed at all times, competent subcontractors are retained, and jobs are performed in a good and workmanlike manner.

Stephen M. Phillips is a partner with the law firm Hendrick, Phillips, Salzman & Flatt, Atlanta.