If you are just starting a small business or have a sole proprietorship, you have probably thought about and received advice about either incorporating or forming a limited liability company (LLC).
What protections do these business entities actually offer to the small business owner?
You have probably heard that by incorporating or forming an LLC, you, as the owner, will be protected from personal liability, whether through contract (from creditors) or tort (from intentional or negligent wrongful act, injury or damage other than breach of contract).
This is true to a great extent. However, as a small business owner you are probably not totally shielded from personal liability even if you do incorporate or form an LLC.
Commercial landlords will often demand a personal guarantee from the principals or owners of the small business despite business entity status. A lease is a contract between a landlord and a tenant. If you have not been in business for very long or your business assets are limited, you can expect to be asked to personally guarantee a lease. Your spouse may also be asked for a personal guarantee. Depending on how long you have been in business or how in demand the property is, this may be a negotiable point. You might want to contact a business attorney to review and negotiate your commercial lease.
Bank loans. Whether you need a loan to finance inventory or to expand, a lender may require you put up your personal property as collateral. Even if your business were to dissolve, you would remain personally liable for paying back the loan. However, depending on the business’ creditworthiness, this too is open to negotiation.
Small Business Administration loans. The SBA requires that all loans they guarantee must be collateralized with both the business assets and a personal guarantee. Often you may need to take out a second (or third) mortgage on your home. Nevertheless, SBA loans often have excellent terms.
Most business credit card issuers will not approve a business application unless the owner personally agrees to be liable for any debt incurred. Take note that any default on your business card will impact your personal credit. After several years of being established, you may want to ask the issuer to allow you to separate your business and personal liability.
Your own acts. Corporate/LLC formation provides protection for corporate acts; it may not provide protection for your own acts. Even if you are acting for the corporation, if you are negligent you are potentially personally liable. You can’t commit intentional wrongdoing even in the guise of your corporate self. You can’t embezzle, defraud or assault someone.
Your employees’ acts. Although in theory, the corporation or LLC should shield your personal assets from your employees’ bad acts, in reality, if the act is egregious enough you are likely to be brought into the lawsuit. Negligent hiring, failure to ensure the person you sent on an errand has a clean driving record, or negligently maintaining your property are just some of the ways you personally can be brought into litigation, even though you’re incorporated. This doesn’t necessarily mean you will lose the lawsuit, however, even good defenses cost money.
You can be held personally liable if the corporation neglects to pay over to the IRS the employees’ share of withholding and social security taxes. Many states also will hold corporations personally liable for failure to turn over retail sales taxes due from the corporation.
Despite some pitfalls and incomplete protection, it is still worthwhile to either incorporate or form an LLC. Business formation will protect your personal assets to a great extent. The longer your business exists, the more creditworthiness your business can show, the better your bargaining power will be with landlords, credit card companies and lenders.
It is a good idea to ensure you have sufficient personal insurance coverage on your assets to cover any business liability. Consider buying an umbrella policy for your cars and home. Insuring your business is also a necessity. Should you get sued, the insurance company will defend you, pay for your attorney and pay up to policy limits.