Many real estate investors and business owners often ask whether they should use an umbrella insurance policy or an LLC/Corporation to protect them from liabilities that may arise on their rental property or business. To understand which you should use you first must understand how they protect you. Unfortunately, I have found that most people who have an umbrella policy misunderstand what it actually protects. An umbrella policy is a policy of insurance that goes on top of and that adds additional liability coverage amounts to insurance coverage you already have. So, if you have auto insurance with $200K of liability coverage and business general liability insurance of $500K, then a $1M umbrella policy is going to give you $1.2M of auto liability coverage and $1.5M of general business liability coverage. The umbrella policy does not cover any additional areas of liability or risk, instead, it solely adds more coverage to coverage you already have. Because an umbrella policy does not cover additional areas of risk, but rather adds more coverage to areas you already have coverage, it isn’t as great of an asset protection tool that many people think it is.
Consider an example of a recent client of mine who was an LLC and who provided home appliance services to residential and business customers. There was a claim made by a customer against the client’s LLC for damages from an expensive failed appliance. The customer brought a lawsuit against the client’s LLC. The client had general liability insurance and an umbrella insurance policy and made claims on both. Both claims were denied by the insurance company as the general liability policy did not provide coverage for product defects. Since the general liability policy was useless and didn’t provide coverage the umbrella policy was also useless. The client did have an LLC, so their personal assets were not at risk but the business could still end up getting a large judgement against it. The case was settled by the parties but the client was really frustrated with an “umbrella policy” that he thoughts was covering gaps or areas of liability that he didn’t have coverage for. So, if you’re considering an umbrella policy, keep in mind that it only gives you more coverage in areas where you already have existing insurance coverage. The use of the word “umbrella” is a great marketing tool but anyone buying an “umbrella” policy hoping to take cover from liability may be surprised that the umbrella is full of holes and is only going on top of whatever umbrella you already have over your head.
An LLC (as well as a corporation) , on the other hand, protects the owner of the LLC from liabilities that arise in the LLC and prevents a plaintiff from being able to go after the LLC owner personally. As a result, we often say that an LLC protects a business owner’s personal assets from the risks and liabilities of the LLC business. What is at risk though in a lawsuit against the business entity (LLC or corporation) is the assets of that business itself as a creditor could collect against the assets of that business. So, for example, if you have an LLC with multiple rental properties with equity then those properties and their equity would be at risk in a lawsuit.
There are many issues and factors to consider in making this decision and there is no one-sized fits all recommendation. In many instances we recommend that you have both an LLC and an umbrella policy and in other instances we may recommend just an LLC or just an umbrella policy. The first factor to consider is the cost. The cost of an LLC in our office is $800 and on average you can expect about $$50-200 in fees a year to keep that LLC active with the State (about $900 annually in California, each state is different, AZ is zero). As a result, the major cost of an LLC is in the first year but you can plan on having about $50-200 in fees each year (each state is different) to keep your LLC active. If you have a partnership LLC or a corporation then you also have the cost of a LLC partnership tax return or a corporation partnership tax return.
An umbrella policy is typically paid for monthly. Let’s say you are able to get $1M in umbrella protection at a cost of $50 a month. That would run you about $600 a year. Insurance policies have benefits which include attorneys whom the insurance company will appoint and pay to defend you (and protect themselves from having to pay) but also contain certain exclusions to coverage that may leave you with no coverage for the liability you incur. Another important factor to consider is the type of property you own. If you own a multi-unit property or commercial property we would recommend having both an LLC and an umbrella policy because you have more liability exposure when you have more tenants. On the other hand, if you have a single family rental in an otherwise good neighborhood where you feel less likely to be sued then we may only recommend an LLC or an umbrella policy on its own. Bottom line, consider both an LLC and an umbrella policy in your analysis and get quotes and advice upon which to make an informed decision so that you are protecting your assets in the most efficient and effective way as possible.
And lastly, I did hear an insurance joke today that relates to deciding on what insurance to buy so I might as well share it here. If you’re a transformer, do you buy auto-insurance or life insurance?