I’m consulted quite frequently on the efficacy of using an LLC to protect oneself from personal liability. I find that most people, including prospective clients and their advisors, believe the LLC to be the magic carpet that will carry them far, far away from personal liability should potential litigation start to appear on the horizon. Well, magic is rarely a defense, and throwing your liability-prone asset into the arms of the LLC may not get you very far.
This myth is promulgated by a loose understanding of the liability protection offered by the LLC. The LLC is certainly a behemoth of an entity that acts as a barrier between the liability-prone asset and the individual, such that claims arising from the asset are cocooned inside the LLC, thus avoiding the problem of personal liability for the individual. However, rental property presents an interesting set of problems for the efficacy of the liability shield, problems that are too often misunderstood.
By way of example, let us look at one very common scenario where the LLC will not protect you:
Negligence and Maintenance of Rental Property
LLCs cannot hold a hammer. LLCs do not know when the rental property is in disrepair. LLCs are not capable of fixing anything. LLCs do not know anything.
When something needs to be fixed, quite evidently, it is not the LLC that does it but rather (in most cases) the owner of the LLC. Will the LLC protect you from personal liability then? Let us explore the issue through the following hypothetical:
You put your rental property in an LLC because your accountant said it will limit your liability. After renting it out, the tenant calls you because one of the screws holding the railing on the stairs popped out. You visit the property the same day and make the determination that the other seven screws will still hold it securely in place, as it has done in the past, and the tenant agrees. The handrail buckles when the tenant uses it and the tenant breaks her leg; she can never walk the same again.
The tenant consults with one of the many personal injury lawyers in town who agrees to accept her case on contingency. The lawyer files suit against the LLC, as owner of the property, the latter of which is worth $200,000.00, and also names you personally as a defendant. You read the complaint and come to find out that the tenant is suing you personally under the doctrine of negligence for failure to fix the handrail. Your attempts at defending prove futile as your negligence has nothing to do with the LLC’s ownership of the property. The jury ultimately finds that a reasonable person, in the same situation as you, would have fixed the railing. Judgment for the plaintiff in the amount of $100,000.00.
To make things worse, you mortgaged the house for $180,000, meaning there is only $20,000 in equity left. The plaintiff then recovers the remaining $80,000 from you personally, at best, or the entire $100,000 jointly and severally, at worse. In this case, the LLC proved useless at protecting you from personal liability, and will continue to do so for as long you make (or don’t make) repairs to the property.
In theory, most people understand the LLC to work like this:
Here, the owner (on the left) owns the LLC which owns the house which is rented to the tenant, with the circle representing the protective arms of the LLC that hugs in liabilities. And this is where most people’s understanding of liability protection stops. As explained in the hypothetical, allegations of negligence actually sidestep LLC liability protection in these types of cases because it is you that is negligent (you did not fix the railing), and not the LLC (incapable of fixing the railing), as represented in this illustration:
Moral of the Story
Be wary of any advice that has a just-put-your-property-in-an-LLC kind of approach. There are many factors at play and a full discussion of your particular situation and risk tolerance, etc., is crucial to understanding the implications of the LLC approach, nearly all of which is based on tenets of the law. In addition, liability insurance and the use of management companies should certainly form part of the discussion, as well as your observance of corporate formalities, but for now suffice it to say that the LLC, alone, is no magic carpet.