Many people think forming a corporation or LLC makes you “official.” It can be helpful, but it’s important to understand what it does and doesn’t do for you.
How does an LLC protect you?
The general rule for corporations and LLCs is that business owners have personal asset protection for business debts.
If your business is sued or can’t repay a loan, the other party can take your business assets, but they can’t take your house or other personal assets. Your loss is limited to your investment in the business.
As is the case with general rules, there are exceptions to when you can’t be held personally liable. This is especially true when you’re personally doing the work.
Related: If you’re a landlord, check out the pros and cons of having an LLC for rental property. If you’re an investor, learn more about using an LLC to flip houses.
What liabilities does a business face?
There are several different potential liabilities when you’re running a business. These could range from someone slipping and falling in a store to your client getting sued out of business due to a mistake you made.
For damages caused by your own personal actions, it may be possible for someone to bring a lawsuit against you personally even if you’re operating under a corporation or LLC.
Example of Personal Liability Even with a Corporation
Let’s say you own Barbershop, Inc. and your employee accidentally cut off a customer’s ear. Barbershop, Inc. would typically be held liable for its employees’ negligence in performing business services.
But even if Barbershop, Inc. didn’t have enough money to cover the claim, corporate liability laws would usually mean you as the owner wouldn’t have to pay the difference out of your personal savings account.
Now let’s say you’re the one that cut off your customer’s ear. Your customer can sue Barbershop, Inc., but the law in some places allows the customer to sue you personally since you’re the one that did the cutting.
Since the lawsuit is against you personally, having the business inside of a separate legal entity may not do you much good.
Using Insurance to Provide Liability Protection
The solution to avoiding personal liability is usually insurance. This might be malpractice insurance, errors and commissions insurance, or commercial general liability insurance depending on what type of business you have.
The next thing to consider is whether you have any liability risks that aren’t covered by insurance.
For example, let’s say you perform remote bookkeeping services, don’t have employees, don’t have an office where clients come, and don’t go to your clients’ locations. You may need to buy insurance for errors in your work but may not have to worry about physical injuries or other types of lawsuits that a corporation or LLC would guard against.
When does a corporation or LLC protect you from debts?
There are three main debt situations that you need to be aware of when considering your business structure.
- General business debts in the business name. For a loan or bill due in the business name alone, the business owners will almost never have personal liability.
- Business debts taken out under false pretenses. A lot of people overstate their income on credit card and loan applications. But if you do so to take out business debt that your business can’t repay, the lender may have a personal fraud claim against you.
- Personally-guaranteed debts. Most small businesses will fall into this category. Because of the size of your business, when your business takes out a credit card or loan, the bank will usually require you to sign a personal guarantee. A personal guarantee means that even if you have a corporation or LLC, the bank can come after you personally for repayment. Hint: Always read the fine print when taking out business loans.
Piercing the Corporate Veil
Piercing the corporate veil is a claim that says your corporation or LLC would usually shield you from liability in this situation, but your corporation/LLC is invalid, so you should pay personally. Basically, you weren’t actually acting like a corporation or LLC with things like:
- Using business bank accounts for personal expenses.
- Using personal bank accounts for business expenses.
- Other ways of mixing personal and business assets.
- Not keeping shareholder meeting minutes or other required documents.
- Other actions that demonstrate you weren’t running your business separately from your personal affairs.
Small business owners can and often do get in a lot of trouble in this area. Yes, it’s all your money, so you’re not stealing from anyone if you use the corporate card to pay for your vacation.
It’s still a bad move to run personal charges through your business accounts. If you want to have a corporation or LLC, you need to treat it basically like you’re working for someone else’s company, pay yourself a salary, and make sure you follow all of the technicalities.
Corporations and Limited Liability Companies still have benefits, but they may not give you full protection from liability. Full protection may require you to take additional steps like purchasing insurance. In some cases, you may have no liability risks that a corporation or LLC would protect you from.
Since laws vary by state and the protection you need varies based on your specific situation, ask an attorney at a business law firm in your area how an LLC protects you under your local laws. In addition, ask an insurance agent about what kind of coverage will help you.