Using Corporate Structure to Manage Liability
As longtime readers know, many of our blog posts are born out of repeated client questions. The more often we hear a question, the more likely it is to become a post. This one is a good example. Over the past few months, we’ve received several questions about how corporate structure can help limit liability.
For example, a single LLC owns the property, operates a summer camp, and also operates a retreat center during the off-season. The client asks: How can we insulate the summer camp from a claim brought by a retreat guest?
In another common situation, a camp operates at multiple leased locations, often in multiple states. The client asks: How can we limit our Connecticut program’s exposure to a claim arising from the New Jersey program?
With these types of situations in mind, let’s explore how to use corporate structure to potentially segregate the liabilities of distinct businesses or locations.
The Liability Shield
The starting point is a basic principle of business law called the liability shield. A corporation or limited liability company (LLC) is a legal entity that’s separate from its owners. Generally, its debts and liabilities belong to the entity itself; the owners are not personally responsible simply because they own the business. Thus, when an LLC loses a lawsuit, the judgment is due from the assets of the business. The members of the LLC (i.e., owners of the business) don’t become liable just by virtue of being owners. The same principle can help insulate different businesses from each other’s liabilities.
Going back to our prior example, assume the Connecticut camp, New Jersey camp, and five other locations all sit in the same LLC. If any one of those locations is sued, the assets of the entire entity are at risk. By contrast, when the Connecticut camp sits in “LLC A” while the New Jersey camp sits in “LLC B,” it goes a long way towards protecting the Connecticut assets from a claim arising in the New Jersey program.
Along the same lines, if a single company owns the property and operates both the summer camp and retreat business, then a judgment arising only from the retreat center can put the assets of the entire company at risk. By contrast, when the property is in one LLC, the camp is in another LLC, and the retreat center is in a third, it creates a basis to argue that the camp’s assets should not be exposed to a claim against the retreat center.
While proper corporate structuring can provide meaningful liability protection, there are two important limitations to keep in mind.
Limitation 1: A Party’s Own Negligence
The first limitation is that the liability shield does not protect a party from the consequences of its own negligence. If a plaintiff establishes that a party independently did something wrong, it’s still liable. For example, if a retreat guest falls because of a dangerous staircase, the landowner may be liable for maintaining the property in a negligent condition. The fact that the retreat guest contracted with the retreat center (its own LLC) doesn’t mean that the landowner (a separate LLC) is protected from the consequences of its negligence.
By contrast, the landowner LLC is more likely to be protected when the claim arises solely from the retreat center LLC’s actions. For example, if a guest sues over a retreat employee’s negligence — and the landowner had no role in hiring or supervising that employee — the plaintiff may struggle to hold the landowner liable.
Limitation 2: Enterprise Liability and Piercing the Veil
The second limitation of the liability shield is that it only works when the entities actually function as distinct entities. There is an idea in corporate law called “piercing the veil.” In certain circumstances, courts will disregard an entity's separate legal existence and impose liability beyond the entity itself. The applicable standards vary considerably by state, but the general idea is that courts look for misuse of the entity that produces a fraud or injustice.
Here are some of the factors that courts consider when deciding whether to pierce the veil:
The entities commingle funds. They don’t have separate bank accounts or financial records, and multiple entities share funds as if they’re one entity.
One or more entities is inadequately capitalized for its business and reasonably anticipated obligations. The idea is that the owner intentionally doesn’t keep enough assets in the entity.
One or more entities is underinsured.
The entities use each other’s assets without documenting the arrangements or accounting for the transactions. Sharing property or equipment under genuine leases and service agreements can be completely fine. The issue arises when businesses treat their assets as one undifferentiated pool.
Multiple entities are operated as one consolidated entity, and their interests, assets, and operations are intermingled (having identical owners, managers, and employees doesn't help).
One or more of the entities are used to engage in fraud. For example, the owner shuffles money between the entities and personal accounts to avoid paying liabilities.
While the above highlights what not to do, the following best practices can help businesses maintain entity separation and reduce the risk of veil piercing:
Each entity should have its own bank account and accurate financial records. Revenue and expenses should be attributed to the right entity and deposited to the right account.
Each entity should have funding appropriate to its business and reasonably anticipated obligations, along with sufficient insurance.
Shared staffing and services should be documented, with responsibilities and expenses allocated appropriately between the entities.
Families, staff, retreat guests, and vendors need to contract with the right entity (e.g., retreat guests should be signing with the retreat center, not with the camp).
Finally, each entity should follow its governing documents, including their decision-making requirements and other formalities (e.g., each LLC operating agreement will explain how decisions should be made for that entity, who votes, etc., and those processes should be followed).
Enterprise Liability
It’s also important to mention that some states specifically recognize a form of piercing the veil called “Enterprise Liability,” in which affiliated entities may be liable for each other’s obligations. For example, in Mortimer v. McCool (2021), the Pennsylvania Supreme Court recognized a form of enterprise liability based on the following veil-piercing test: “First, there must be such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist, and second, adherence to the corporate fiction under the circumstances would sanction fraud or promote injustice.” See this article for the PA analysis, and keep in mind that this is a state-by-state question and something that needs to be analyzed before your attorney engages in a corporate structuring project.
Conclusion
There are other legal considerations that need to be considered as part of this process. For example, moving appreciated land out of an entity can trigger significant taxes. Restructuring corporate entities may also require lender or landlord consent, contract assignments, updated camp registrations, new operating permits, corporate filings, updated insurance policies, and so on. Taking all this together, some camps will conclude that this process just isn’t for them — the juice isn’t worth the squeeze. But following fact-specific legal analysis, other organizations will determine that separating distinct operations into multiple entities will help limit liability in meaningful ways.
