Software Liability Issues

Several times on this board the issue has been brought up of the issue of legal liability of people who are self employed and write software.

The issue is that any time you distribute software to the public, you expose yourself to legal liability in terms of lawsuits. For example, if your software is compromised by a virus because of a fixed buffer weakness, you can reasonably be expected to be sued by a user who lost data due to the virus because as a professional software developer, you should not have had any exposed fixed buffers since that is a well-known problem. Or if your software is being used during a live performance and fails and ticket holders are refunded, the production companies insurance company will hit you with a lawsuit for all the money lost. Or if your software crashes due to an omission in testing coverage and the crash causes the user's hard drive to become corrupt and lose valuable data and the error is traced back to your program, you can be held liable for the errors.

These liability issues are true whether you charge for the software, distribute it as shareware, or give it away for free. (The separate issue of how to freeware developers afford insurance is one that I wonder about but isn't immediately relevant.)

Now here on this board I have heard of two active methods being used by members here in dealing with this:

1. Forming an LLC to shield you from all liability.
2. Every contractor needs errors and ommisions insurance.

I would like to touch on the my personal recent experience with these issues, which I think will be valuable to many others on this board and also ask for others' direct experiences. Since laws vary everywhere and I am in the US, I would ask that experiences shared by constrained to those with actual experience operating under US law, or if sharing legal insights from other countries, please specifically identify the country you mean. Also, I know there is plenty of common wisdom and 'things that every one knows', but many of these things are actually not true, so if the discussion could be limited to things people have real experience with, and please state the specific experience so we can see the exact context.

I know many contractors who have formed LLCs. For some time several of them have been harping on the need for me to form an LLC since I sell software. Others have suggested errors and ommisions insurance. The LLC proponents have said that insurance is not needed if you have an LLC since it 'completely shields you from all liability'. I could not determine the facts myself, and so we (myself and my partner) retained an attorney to advise us in these matters. He stated that not only was an LLC perfect for completely shielding us from all liability and it was something he could set up. We asked him about the law regarding tax status of an LLC as compared to other types of corporations and also to a sole proprietorship. He stated that unlike a standard corporation, an LLC is taxed identically to a sole proprietorship, which is what I was filing as now. The only additional cost would be a yearly 'renewal fee' of 'less than a hundred dollars' and there would be 'no additional costs beyond those of a normal sole proprietorship'. Based on this advise, we agreed to pursue the LLC and filed incorporation papers. There was a substantial cost involved in both the filing fees and the attorney fees. Do note at this time that if he had advised us to get insurance instead, we would not have to have paid him any fees.

Although he claimed to have extensive experience in filing business incorporation papers, the papers he submitted to the state were in such a disarray that the state returned the papers as unacceptable. He filled them out again and sent them in, they were accepted, and the company was incorporated as an LLC with myself and my partner as equal owners. This process inexplicably took three months.

We recieved a package from the state and discovered to our shock and dismay, that in our state (each state is different), LLCs are taxed the same as full corporations. That is to say that we were now responsible for accounting for every detail of our business to the state using 'generally accepted accounting principles'. My partner has been figuring out the tax stuff, but is not a CPA. Doing it the state requires would require hiring a licensed CPA with experience keeping corporate records. The cost of this service is not insignifigant. Filing corporate taxes and doing books the proper way is completely beyond our abilities, and the abilites of most people.

We consulted with officials on the state level and explained our story. They said "Your attorney lied to you." and "We've seen this before from certain attorneys advising people to get LLCs who would not benefit from them."

We then contacted the attorney and explained that, contrary to his legal advise to us, it turned out our tax was not 'identical to a sole proprietorship for tax purposes', as his exact words had been, as I wrote down in my notes during our meeting. He seemed unaware of the actual tax issues in the state and initially denied that there was a corporate income tax in the state. I explained how the state law actually was and showed him the exact state documents and relevant laws. He became upset, and changed his story. Now he said that he had explained all about these laws to us and it was our fault for not looking into them. Both of us had been at the meeting and we took careful notes and asked him detailed questions about these issues so we knew for a fact that he had not told us anything about it since the legal issues regarding LLC tax liability were of such great importance that on the list of issues I went into the first meeting with, they occupied the first handful of checkboxes that I checked off as we discussed them during the meeting and I wrote down the exact words of his responses as he said them.  I explained this to him and he stood up and started yelling. He said we were accusing him of being a liar and had insulted his honor. He suggested that there would be a price to pay for doing so and that we should get out of his office. There was a bit more discussion, but nothing was resolved and we eventually left.

We then consulted with a different attorney. Need I point out that the first one came highly recommended from reputable people? We found an attorney with many years of verifiable experience  and told him our situation. He was pretty shocked about it and said "Your attorney is either incompetant or has been lying to you. Your highest priority should be to fire him immediately and you should consider a malpractice suit or at least reporting him to the state board." He explained that the ironic thing was that AN LLC DOES NOT PROTECT YOU FROM LIABILITY. I know this is going to be a shock to many of us, because this is not the 'common wisdom', but here is the deal -- an LLC protects investors from liability and in no way shape or form protects those doing the actual work. Investors are people who are part owners in the business. As both the owner AND the developer, I 'wear two hats'. As a owner, I am protected from liability. But as the person who actually develops the software, I am 'wide open to liability'. If there was a problem with the software, anyone who wanted to would name me AND the LLC as parties to the lawsuit and if a judgement was ordered, that judgement would certainly, without any doubt whatsoever, apply to me as an individual. Any attorney who advises differently from this, is not advising people correctly according to law, according to the second attorney. He said an LLC is totally wrong for this purpose and that the only thing that will protect me is to have business liability insurance, which is the standard and accepted way of handling this issue. The people who form LLCs to shield themselves from liability 'don't know what they are doing and are wasting their money for a false sense of security'.

So we set about dissolving the LLC. Well here is the interesting part. We were still responsible for the taxes on the LLC, in addition to the fees for dissolving it. Not only is there a corporate income tax which is a flat tax on ALL GROSS INCOME, before deductions, but these taxes include a state flat 'franchise tax' on the actual value of the real property value as well as on the 'Net Worth' of the business, as calculated on a "Balance Sheet" which is prepared 'in accordance with standard accounting practices.' Now the Net Worth of the business includes, guess what folks? That's right - the value of intangible assets of 'business value' such as intellectual property, like -- all software I have written.

So now we wondered, how do we assign a value to the software I have written? Is it $0? Can I make up a value? Extensive checking around led us to the answer -- the nominal value of such an asset is normally prepared by an 'independent appraisal of software' done by a 'valuator'. This is a highly skilled appraisal expert who will change you an absolute fortune to go over your code base and evaluate your software in detail to figure out how much it is worth. He may figure that, even though it took you 3 years to develop because you are such a fast coder, that the software actually represents 30 man years of development effort, if you are, say, one of those weird guys that's ten times as productive as the average. If that is the case, then he will take the standard wage of someone with the skills necessary in the area (likely $65,000 for where I am at based on salary surveys) and multiply it by those years of estimate to come up with the actual nominal intrinsic net worth of the software. So in my case for just one of my programs, that could be $195,000-$1,950,000. Can't really be determined without a proper estimate, but the lower amount would certainly be the least that would be possible to claim.

So that's where we are now - liable for taxes on somewhere between 200 grand and $2 million bucks in 'net worth'. I don't have the money to make this tax bill, unfortunately. Basically, I'm screwed and am going to lose everything, including my house to satisfy the tax bill. I am hoping to come out of this in a few years with no software and no assets, but able to start over with a clean slate and rebuild my life.

I want to use my experience to warn others to avoid the mistakes I have made.

1 Don't trust lawyers, even highly recommended ones. Get a second and third opinion on everything.
2 An LLC will not help you in most cases, despite what 'everybody' says.
3 You need business liability insurance, even if you are only producing freeware.

I've got my email here and will appreciate private as well as public comments but I can't promise to respond to anyone since I am not sure it is legally smart to pierce the veil of anonymity until all this stuff is resolved with finality.

Thanks for listening and good luck to all who follow the path of independence. I do believe that if we share information about our experiences going it alone, we might be able to help each other and help new people avoid common mistakes.

Scott
Wednesday, January 7, 2004

Thanks for sharing your experience Scott.  Is FogCreek an LLC or perhaps an S-Corp?

Wednesday, January 7, 2004

An LLC (or some other type of corporation like S-Corp or C-Corp) can shield you *personally* from liability, but people can still sue the corporation. There is nothing to stop them from going after you as well -- this is called "piercing the corporate veil." The more your corporation looks like a real corporation (with its own books, office, paying you a salary using a normal payroll system, etc) the harder it is to pierce the corporate veil.

You still need insurance, like errors and omissions insurance, general liability insurance, etc., to protect the corporation in case of a lawsuit or in case bad things happen.

It's not an either/or thing, trying to decide whether to get insurance or whether to incorporate. You need to do both to protect yourself and your company.

Keeping proper books is not hard. Most small shops use a PC package like Quickbooks. It's not much harder than balancing a checkbook. If you want to be in business and you don't know how to keep books, bookkeepers are some of the most underpaid people in the world right now and you should be able to hire a part time bookkeeper for a few bucks to come in once a week and type your receipts into the computer. Once a year you send the Quickbook files to a real accountant (CPA) who will file all your taxes, check the books, etc.

As for the franchise tax... well, we're a full fleged Delaware C corp and our annual franchise tax is around $60. I'm not sure what state you're in but I don't know why you should be worried about it. The value of our assets is not some random thing made up by an appraisal of our software... it's simply the amount of money we have taken in since day one minus the amount of money we have spent. Another reason to keep books ;) For us that number is around $100,000 or so, practically nil, because we pay the founders big bonuses to avoid keeping money in the company which would lead to what they refer to as "double taxation."

Long story short. If you're going to start a company, hire a good accountant and a good insurance broker with experience with similar companies on day 1. Your accountant can give you advice on the type of corporation to create, and there are reputable companies (like The Corporation Company) that will file everything for you for around 250 bucks.

If you need names and you're in New York, email me.

Joel Spolsky
Wednesday, January 7, 2004

Scott, you need a 3rd opinion. There is no way you are responsible for $200K-$2M worth of taxes unless you actually sold enough software to warrant the tax (in which case I doubt you would be posting your story here). I have formed and closed an LLC and the only thing I lost was about $600 in filing and accountant fees.

Also, regarding personal liability, you could have simply looked at the nolo press books about forming LLCs - they give you the lowdown and state that they will help you reduce personal liabillity but not guarantee it.

...
Wednesday, January 7, 2004

I sohuld have been more clear on the tax issue - the $200k-$2M is my rough estimate, based on what I have been advised, of likely reasonable appraised value of the software. In this state, the franchise tax is a flat 0.25% tax assesed on the full net worth of the company, or the value of all real property owned, whichever is greater. The full net worth, I am advised, includes 'anything the company owns which is used to generate income'. This includes intellectual property, an intangible asset. The tax is assesed every year. If the value of the software were to come in at the upper range, this alone is ... ok I see, I misplaced a decimal point -- it's $5000, not $50,000 as I was thinking, which would have doomed me. OK, so the tax is going to actually be $500-$5000 which means I don't lose the house to pay the taxes. I am dealing with this now because we have to pay the taxes as part of dissolving the LLC.

I believe that Joel's advise is quite interesting - by going with a full fleged corporation instead of a LLC (since I'm liable to file the taxes on one anyway), I may be able to have better liability protection. The concern here is with getting sued and losing my house and such. The new attorney is very sure that the LLC affords no protection in these circumstances. I will ask him if a full fledged corporation does what our intent is when we next meet with him.

Thanks much.

Scott
Wednesday, January 7, 2004

Dear Scott,
                  You seem to have got absolutely lousy advice. A bit of common sense would not have come amiss. How many software companies have ever been successfully sued for liability because of data loss?

                    There are good reasons for starting an LLC, the main one being that it does protect your house against the company's creditors. However software companies traditionally have very low outgoings, so the more normal reason is to clarify relations between partners.

                    If you want to wind the company up (and having set it up you might find it better to continue) just set the value of your software at next to nothing (much as it will hurt your ego that is probably true) and tell your accountant/lawyer exactly what you want him to do.

                    I may add that I have regularly used lawyers in Spain, Saudi and Sri Lanka for criminal, labour and civil matters and been more than satisfied in every case, so the problem is not a general one in the profession.

Stephen Jones
Wednesday, January 7, 2004

Scott, I think you are totally overreacting. Certainly it sucks to receive bad advice, but I don't even see any reason to shut down the LLC. You are shutting it down just because it doesn't offer liability protection?  I'm pretty sure that unless you are writing trading software that loses a bank $100M or software that causes people's pacemakers to explode, you won't be sued anytime soon.

You state that you paid substantial fees to incorporate, but the maximum cost to form an LLC in any state in the US is $600. In most states the fee is between $100 and $300. So unless your lawyer costs $80,000 per hour, I can't imagine a situation where you are losing more than a grand. 

I think you need to step back for a moment, and take a few deep breaths. People start and flop LLCs and C corps all the time without losing their shirts to the IRS.

Wednesday, January 7, 2004

Also, as Joel mentions above, I'm not sure where you are getting the idea that there is some independent asset evaluator who is going to assess the value of your software. Whomever is giving you that line is also bad counsel. Your assets at this point are just whatever monies your LLC has in the bank.  If you have none, that is the point you should be concerned about, not that you might owe the IRS some imaginary astronomical amount.

Wednesday, January 7, 2004

I think it's pretty much the case that you may end up losing the house no matter which corporate structure you have, given a bad day.  There are so many cases where the corporate veil might be pierced for one reason or another that no lawyer is going to be able to tell you 100% that your personal property is safe.  The whole corporate responsibility movement just means that you can still lose your house.  And then there's the games where you transfer the title of the house to your wife so that they can't take that, etc. which may or may not work in practice.

The obnoxious minimum-taxes that some states have taken to placing get on my nerves, too.  Works great in failed business ventures. :/

I love the non-traditional corporate structures.  Every state has them a little differently and there's often a few different types of them, with whichever has been passed most recently as the most preferential.  He may have gotten his LLP and LLC's screwed up.  LLP = partnership with benefits, LLC = corporation with benefits.

My personal advice is for at least one of the members of any company to be fluent in regulation-ese and be able to, by viewing applicable state publications and potentially state commercial code, make an educated guess about what the law probably says *before* you consult a lawyer  For one, it's cheaper and for another you can desk-check what they think.  It's really no different than hiring somebody to do anything else, you either need to check them somehow or trust them.  Trust should be an upgrade.

I have actually met some lawyers in the US who were trustworthy and honest.  It's like programmers before the crash or perhaps doctors.  Some people got in there because they wanted to do it, some people got in because they wanted the money.  The problem is that some people become lawyers because they want to be a weasel.

Flamebait Sr.
Wednesday, January 7, 2004

Also, it sucks to go up against a lawyer, but you really should, as a public service, try to get the dude disbarred. ;)

Flamebait Sr.
Wednesday, January 7, 2004

"The problem is that some people become lawyers because they want to be a weasel. "

....and because majoring in political science then going to law school doesn't really much grey matter, either.

Huh?
Wednesday, January 7, 2004

"Tax Savvy for Small Business" by Daily is a good comparison of the benefits and drawbacks of the available business structures.  Much cheaper to read a book like this and then talk to a lawyer, as Flaimbait said.

Scot Doyle
Wednesday, January 7, 2004

The first attorney wasn't wrong, it's just that his advice was incomplete.  I think the second attorney might have scared you unnecessarily.

First, if your goal is to protect your personal assets in the event of a lawsuit, an LLC (or a regular corporation) is an excellent way to go.  The LLC basically sets up a firewall between the company's assets and your own.  If someone sues the corporation, they might (theoretically) be able to bleed the company dry, but they won't be able to reach your personal assets like your house. 

(There's one exception called "piercing the corporate veil" under which a plaintiff could theoretically reach your personal assets, but this is very rarely successful -- only when the business owner is ignoring the firewall himself, like by dipping into the corporate bank account to pay for his ski vacations.)

Incorporating isn't a panacea, since the business's assets are still at risk.  (Which is why insurance could be useful.)  However, it does offer the benefit of protecting your individual assets.  Also, an LLC generally offers the same liability protection that a traditional corporation does.

Second, your first attorney was halfway right about the tax issues -- an LLC can be taxed like a sole proprietorship for *federal* tax purposes.  If you file the right paperwork with the IRS, the LLC won't pay federal income tax itself, but the tax burden is instead passed along to the individual investors/owners.  State law may obviously differ.

I'm not defending the first attorney -- he had an obligation to consider all of these issues and explain them to you.  However, there's no reason to disolve the LLC, unless the state tax burden is unacceptable.  I strongly agree with the advice to do some research on your own next time before meeting with an attorney -- you'll have a better understanding of the issues involved and be better prepared to ask the right questions.

Robert Jacobson
Wednesday, January 7, 2004

Scott, your code probably doesn't have any value in the business sense, so you wouldn't have to pay tax on it.

Valuers of business are hard-nosed. They look at whether anyone is actually paying money for something and, if so, how much.

Also, if you developed the code over a long time, surely the business (your company) was paying you? If not, the company owes you money and you could deduct that from any positive valuation of the code.

Thursday, January 8, 2004

I'd be astonished if a corporation were taxed on net worth instead of profit.

Simon Lucy
Thursday, January 8, 2004

When people sign your software license doesn't say, as is the case with most software, that your software is in no way guaranteed to function and may end up killing the user's children and you assume no liability whatsoever?

Also when fearing lawsuits bear in mind that it has to be worth it to sue you.  A large corporation is very unlikely to sue you if you are only worth a few bucks.  I am fairly certain they cannot get your primary residence and my guess is you are worth almost nothing without it.

Name withheld out of cowardice
Thursday, January 8, 2004

Even if the corporation were taxed on the value of its assets, couldn't you (the corporation) just sell the assets to you (the person, or anyone else for that matter) for a nominal fee, so that the corporation doesn't have the problem of valuing the IP?

On the other hand, I'm sure if someone came looking they'd want some assurance that this transaction happened at some reasonably fair value, which is likely why some dissolving companies end up auctioning off their IP...

(Not only am I not a lawyer, I don't really have any clue what I'm talking about...)

schmoe
Thursday, January 8, 2004

Correct me if I am wrong, but doesn't most software come with a liability disclaimer such as the following:

"Under no circumstances, including, but not limited to, negligence, shall <your company>, its subsidiary and parent companies or affiliates be liable for any direct, indirect, incidental, special or consequential damages that result from the use of, or the inability to use <your company> services. You specifically acknowledge and agree that <your company> is not liable for any defamatory, offensive or illegal conduct of any user of the free forums created using the <your company> service. If you are dissatisfied with any remotely hosted forum material, or with any of <your company> terms and conditions, your sole and exclusive remedy is to discontinue using <your company> services. "

Doesn't this disclaimer protect you from lawsuits in case something bad does happens? I am not talking about people getting killed, but more along the lines of someone losing their data and such.

Most users don't read license agreements anyway and you'd think that big customers -say a bank- would read the agreement and either not use your software due to the risk of losing millions and not being able to sue you based on what they agreed to in the liability disclaimer.  :-)

Citizen
Thursday, January 8, 2004

Actually, depending upon jurisdiction and blah, blah, although you might exclude all sorts of liability and fitness for purpose tests in a licence that doesn't mean such exclusions are either lawful or to be relied upon in all circumstances.

Shrink wrap licences (and its arguable that click this button to accept a licence after you've spent your money are also shrink wrap), which have the warning 'open this envelope and you accept whatever is inside' are generally unenforceable to the extent of excluding all liability.  And of course no contract can excuse a company from abiding by a law so any statute about  advertising and contract law about fitness for purpose still covers software regardless of whatever is in the licence.

That said anyone providing a service should have professional indemnity cover and any corporate entity should have similar product liability insurance.

Simon Lucy
Thursday, January 8, 2004

I'm in South Africa, so I don't know USA law, but ...

Over here the LLC would only own the software if it either paid the development cost or if you formally "sold" it to the LLC.  If you formally sold it, then I guess that sets a value on it, and you can buy it back from the LLC.

ie In your head you see the LLC as owning the software, but unless there is formal paperwork to that effect it probably doesn't.

We recently went through a process of selling one business to another, and determining the "value" of the software sold was one of the big thumbsucks.  Basically we tried to make an honest valuation, but it's a bit like a lottery ticket.  It's might be worth a zillion dollars, but (despite our egos) most likely isn't. 

The eventual valuation had to do with past results, and realistic future estimates. 

In the current climate I doubt any legitimate valuator would over-value any software based business, especially if it doesn't have some sort of trading record to work from.

Cheers
Bruce

Bruce Johnson
Friday, January 9, 2004

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