One of the big reasons for forming a business entity is to limit an individual's liability, protecting their personal assets from any business-related legal claims. Here are a few ways to do this, as well as some ways that a business owner can lose this limited liability benefit.
Ways to limit liability:
One way to limit liability is to form a business entity that limits liability. Some entities, like sole proprietorships and partnerships, do not contain such protections. However, popular entity forms like corporations, LLCs and limited liability partnerships do have liability protection for owners and shareholders.
Another way to limit liability is through the purchase of general liability insurance for the business.
Ways to lose your limited liability:
For business entities, there are two main ways to ruin your limited liability and allow plaintiffs to “pierce the corporate veil.” These are the so-called “Alter Ego” theory and Undercapitalization.
The first exists when the business person is treating the corporation or LLC as essentially themselves, and not a separate entity. This means that they are not observing corporate formalities, such as holding annual meetings and keeping minutes and records of those meetings.
The second is when there is not enough money put into the business entity, which also speaks to its use as a “sham” or “fraud,” merely meant to escape liability for the person who started the entity.
The Wikipedia article on the subject has a great list of factors that courts look at to decide whether piercing the veil is appropriate.
In the case of insurance, there are plenty of ways that an insurer could deny coverage. These include:
Misrepresenting or breaching the warranties given when coverage begins
The damage caused was either expected or intended
When the businessperson is aware of the liability prior to getting insured
Breach of duties
Claims outside of the scope of coverage or outside of the policy period
It is generally a good idea to have both limited liability methods working for your business. For those with no assets or low-to-no risk businesses, a business entity that doesn’t limit liability could be appropriate, but they should probably still get liability insurance just to be safe.