Consultant Liability and What to do About it

by Michael DeLaurentis, Esq.

Every small business needs to consider all aspects of potential liability and how best to protect against it. Consultants usually are independent contractors, which means, among other things, that they face the possibility of unlimited liability for personal or property damage attributable to their negligence in providing advice or other services. This is just as much the case for consultants who obtain some or all of their work through one or more intermediary agencies. There are generally three ways to limit liability: buy insurance, provide for its limits in contracts, and operate through a limited liability entity. (A fourth way - personal asset and liability planning - is beyond the scope of this article.)

A consultant's engagement letter with clients and its agreements with vendors and others can specify which party will bear which liability, and set limits to the maximum liability. An engagement letter, for example, might provide that the consultant's liability is limited to the fees paid under the engagement, regardless of actual damages alleged to have been suffered as a result of consultant negligence or breach of contract. The extent to which such clauses are enforceable depends on the particular facts of each situation and the jurisdiction(s) involved. This may be especially troublesome in transnational engagements. Providing for arbitration or mediation may also limit costs of dispute resolution and provide a more streamlined and knowledgeable outcome.

There's insurance coverage for virtually any imaginable risk. Whether the cost of protection is affordable is another question. Disability buy-out insurance, for example, in the event of a co-owner's disability, is notoriously expensive. General liability [and "umbrella"] insurance will cover most aspects of personal or property damage resulting from alleged negligence, and property and casualty insurance can provide protection to property and assets. Business owners typically take care of life, key-man, health, and disability coverage, but may not consider professional liability (PL) --- or "errors and omissions" (E&O) - protection. Until comparatively recently, PL coverage was available only for licensed professionals: doctors, lawyers, architects, etc. Now, all sorts of service enterprises can find coverage for liability resulting from alleged failure to fulfill contract obligations or damages alleged to have resulted from negligent provision of contracted services. For unlicensed services groups, a trade association frequently will offer coverage tailored to the needs of the particular group. E&O coverage for chemists, for example, is offered by the American Chemical Society. Because trade association policies are tailored to a particular service group, they can be cheaper, more relevant, and provide better quality than comparable policies from commercial insurers. In today's competitive environment, many potential clients will require that a consultant have PL coverage.

Insurance protection and contractual limitations on liability, however, will not necessarily reach all areas of liability or liability in excess of policy amounts or contractual limits. Enter the limited liability entity. For more than a century, the corporation was the principal entity through which to operate a business for maximum protection against liability of owners and officers. In recent decades, the rise of the limited partnership and, more recently, the limited liability company ["LLC" and its professional variants] have caught up with and overtaken the corporation as a vehicle for limited liability. This change is largely attributable to greater flexibility, generally more favorable tax treatment, and lower start-up and maintenance costs of the newer entities by comparison with the corporation. For a service business like a consultancy, with a single owner and few hard assets, a subchapter S corporation may rival a LLC, and might even offer certain tax advantages [in limited circumstances, the possibility of labeling some distributions to owners "dividends," thereby reducing employment (FICA or SECA) taxation and local earned income taxes]. Advisers generally prefer LLCs, however, because of their much greater flexibility; their tax advantages [ease of withdrawing assets, terminating the business, adding new owners and owner tax basis for borrowings, among many others]; and better owner protection [in most jurisdictions, creditors of LLC owners who attach an LLC interest can generally recover only declared distributions]. There is now also much greater familiarity with LLCs, so that corporations no longer hold that advantage.

Should a consultant even bother to go through the trouble and incur the cost of forming an entity? Doesn't that require additional annual tax filings? The answer to both questions is "Not necessarily." If a consultant, after consultation with insurance, tax, and other advisers, concludes that his or her risk profile is very limited and to a large extent contractually manageable, the consultant may reasonably conclude there is no need to operate through an entity -- or even to obtain certain types of insurance, including PL coverage. If the consultant decides to operate through a LLC and is the sole owner, there will be no difference in tax reporting from operating as a sole proprietor: the consultant need only include a Schedule C with his or her annual tax return. A sole owner of a LLC, thus, has it all: maximum asset and personal liability protection - from the entity's and owner's creditors - simple tax reporting, maximum flexibility, and comparatively low formation and maintenance costs. The presumption should probably be that a LLC is the preferred mode of operation unless facts convincingly demonstrate a contrary course is preferable.

A final word of caution: any mode of liability protection has its limits. Entity protection requires that the owner and employees honor formalities and maintain strict separation of personal and business activities. Contractual protection requires strict compliance with its specific terms, which may not be fully enforceable if facts indicate bad faith. Insurance will not protect against events and circumstances specified in the policy, and few policies will protect against intentional harm, fraud, or recklessness [though even here, it may be possible to have employees bonded via fidelity insurance]. But even with these limitations, some form of liability protection is almost certainly significantly better than none.

Michael J DeLaurentis is a solo tax and business attorney located in Elkins Park, PA, just outside Philadelphia. He has more than 32 years experience in large and small law firms on both coasts, and has consulted as a sole practitioner since 1994. He has spoken at several ACS conferences. His clients include domestic and international businesses, nonprofits, and individuals. He welcomes follow-up questions to this article, and may be reached by email at mjdtax@comcast.net or by phone at (215)519-8076.