Numerous small businesses owners have concern regarding the personal liability associated with their business. Take, for instance, the scenario where a customer slips and falls in your store; you may find yourself legally accountable for any resulting injuries. However, by establishing legal separation between yourself and the business, you can shield your personal finances from the hazards inherent in operating a small business.
When choosing an organizational form for your business, one of the important considerations is limited liability. A limited liability company (LLC) is a business structure that protects its owners (who are called members) from personal responsibility for the business’ debts and liabilities. When you form an LLC, your business assets are separated from your personal assets.
In this article, we explore how an LLC helps with asset protection. We also address misconceptions about limited liability and share tips for lowering the risks to your personal assets from your LLC’s activities.
What is limited liability?
Liability means that you owe something to another party, whether it’s money or a service, and it typically refers to a legal obligation. When applied to an LLC, limited liability means that the members are not liable for the business’ debts. The LLC owns the business and is responsible for its debts. The liability of the LLC’s members, as owners of the LLC, is limited to their investment in the LLC.
Limited liability essentially puts a wall up between your business and personal assets. For instance, if the business owes money to a creditor, that creditor can’t pursue your personal assets to pay off the debt – they can only go after LLC’s assets. That’s because you don’t own the business. Your LLC does.
Limited liability in an LLC protects the owners
Many people mistakenly think that an LLC automatically provides limited liability to the company itself. However, limited liability, in the context of business entities, refers to the limitation of liability for the business entity’s owners, not the business entity itself. An LLC is responsible for its own debts, and it could face losing its assets if a business creditor takes legal action.
In the structure of an LLC, it is the individual members, who are the owners of the LLC, who benefit from limited liability protection when dealing with business creditors.
However, LLC liability protection has some limitations. Members are sometimes held liable for the actions of LLCs and vice versa.
Ways LLC owners can be held personally liable
Here are six ways LLC owners can be held personally liable:
- Piercing the corporate veil: Pay close attention to recordkeeping and initial capitalization to avoid “piercing the veil” of limited liability. When this happens, business creditors can come after your personal assets. This typically occurs when owners of the LLC fail to respect the separate identity of the LLC and treat the business’ assets as their own. For example, if you were to pay your personal bills using a business credit card.
- Loan guarantees: If you personally guarantee a loan to the LLC, creditors can pursue your personal assets if the loan defaults.
- Pledging personal assets as collateral: If you pledge your personal assets as collateral against a business loan, a creditor could seize your property in the event of a default.
- Tax liabilities: LLC owners are still responsible for many business tax liabilities.
- Statutory liabilities: Some federal or state statutes impose personal liability on business entity’s owners when the business entity violates the statute.
- Fraud: An LLC owner is liable for his or her own conduct. For example, an LLC owner may be held personally liable if he or she is found to have committed fraud.
Sole proprietorships and general partnerships do not provide limited liability
Sole proprietorships and general partnerships are two of the easiest businesses to form and maintain, however they are also the riskiest in terms of asset protection.
A sole proprietorship is not considered a separate entity from its owner. This means the owner’s personal and business assets can be seized by business creditors. Moreover, personal creditors can seize both business and personal assets.
Consider this example:
Chris operates her business as a sole proprietorship. Last year, her business suffered severe financial difficulties, resulting in a debt of $1.5 million, due to a loss of market share and default on loans. Chris' personal net worth (unrelated to her business) is $1 million, and she has $50,000 invested in her business.
Because Chris operates her business as a sole proprietorship, every asset she has is at risk. This means Chris could lose her entire personal net worth of $1 million, and well as the $50,000 she has invested in her business.
If Chris had operated her business as an LLC or a corporation, she would have limited her liability for business losses to only what she had invested in the business. Although she could lose the $50,000 because it belongs to the LLC, her personal assets of $1 million would be beyond the reach of business creditors provided she had not personally guaranteed any of the loans.
A general partnership carries the same risks. Plus, there is the additional risk that each owner is fully liable for any misstep by the other partner.
For more information, see Single-member LLC vs. sole proprietorship: Advantages & disadvantages and .
Limited liability partnerships may also provide limited liability
A limited liability partnership (LLP) is a partnership that provides its partners with limited liability. In most states the limitation of liability is the same as that provided to members of LLCs. However, in others the limitation may only be for the negligence of other partners. (Note: an LLP is different from a limited partnership).
Most business owners prefer limited liability partnerships over general partnerships because they don’t want to be held personally liable for the partnership’s debts or for a partner's troubles. For example, in an LLP, each partner is protected from any business debts that arise from professional malpractice suits against another partner. (If a partner loses a malpractice suit, they are still liable.)
In some states, licensed professionals such as doctors, lawyers, and accountants can form an LLP or a professional corporation (PC), but can’t form an LLC. In addition, a sole owner cannot use an LLP because, as a partnership, it requires at least two owners. However, in the states where both options are available the choice generally comes down to whether the business owners are more comfortable with the management structure of a partnership or an LLC.
Undercapitalization and piercing the corporate veil
Piercing the corporate (or LLC) veil is something a court may do in a lawsuit brought against the LLC. It can occur where an LLC member fails to maintain the separation between the member and the LLC, such as by commingling business and personal funds or failing to maintain entity obligations, such as proper recordkeeping or maintaining a registered agent. If the court pierces the veil, the liability shield provided by the LLC’s separate existence is gone and the member becomes liable for the LLC’s debts.
The corporate veil can also be pierced through undercapitalization. This happens when the LLC lacks capital to operate and pay creditors. Undercapitalization doesn’t mean the business is unprofitable, it simply means that the LLC members formed or are operating the entity without sufficient capital to conduct normal business operations and meet its financial obligations. This can expose LLC owners to the risk of piercing the corporate veil. A creditor may be able to prove that the owner(s) deliberately underfunded the business when it was formed to defraud creditors or purposefully keep money out of the business to avoid liability.
When capitalizing your business, be sure to open a bank account with sufficient funds to support business operations. It’s unwise to start a business and use your personal account in the hope of making a profit and putting that money back into the business.
Charging orders
Most LLC statutes provide that a judgment creditor’s rights against a debtor member’s interest in an LLC are limited to a charging order. A charging order is a court order entitling the member’s creditor to receive any distributions that the LLC would have otherwise made to the member. The member’s creditor does not become a member and has no right to assume the member’s management rights. The charging order provision is intended to protect a member from having a co-member not of his or her own choosing (i.e. the creditor).
The charging order is generally designed to protect a member from the debts of another member. As a result, it is not clear if this protection would apply to a single member LLC. The states differ on this issue.
Strategies for lowering risk to personal assets
Several strategies can help lower the risks to your personal assets from your LLC's activities:
- Keep your business and personal assets separate: To avoid piercing the corporate veil, maintain a separate business bank account and records for your LLC. Any comingling of funds could expose you to personal liability. In addition, create an operating agreement and maintain formalities that can help maintain division of authority within the LLC, such as holding required meetings and diligent recordkeeping.
- Get the right insurance: Obtain professional and liability insurance to help protect business and personal assets. Do your research to understand adequate protections and potential policy exclusions.
- Build credit for your LLC: Establishing business credit demonstrates that your LLC is maintained as a separate entity. It can also help your business obtain financing and evidence separation of business and personal assets.
- Establish a trust to protect assets: Asset protection trusts can shield your personal assets from your LLC’s liabilities. Trusts must be set up in advance. However, be aware that assets placed in the trust may not be easy to extricate.
Start your LLC with the formation experts
At BizFilings we’ve formed over 500,000 companies for our customers. Our LLC filing services guide you through the steps and ensure the process is done right. We are with you through the life of your business, providing the support and legal services you need to ensure you stay on top of ongoing LLC requirements.