When preparing to launch your business, you’re probably most concerned with the ways in which your company will turn a profit. However, robust sales figures aren’t enough to keep you in business. On the contrary, owners who hope to outlast the competition must also focus on protecting themselves from lawsuits and other claims. One of the best ways to do so is to select the proper business entity.
The different business entities offer varying levels of liability protection for owners and employees. For example, one of the principle benefits of launching an S or C corporation is that it creates a line of demarcation between personal assets and future business debts. With an S corporation, shareholders can be held liable only for the money they invest in the business. As a result, creditors are unable to seize personal assets in the event of a lawsuit or other loss. Similarly, C corporations and limited liability companies (LLCs) offer limited legal liability for directors, officers, workers and shareholders.
Of course, not every business entity offers liability protection for its owners. A sole proprietorship is one of the simplest types of business entities and one that many businesses operate as. But despite its popularity, a sole proprietorship doesn’t provide any liability protections and thus renders the owner liable for any company debts, judgments and lawsuits. As a result, creditors can lay claim to both personal and business assets following insolvency. Similarly, general partnerships hold all members of the partnership equally liable for claims. If you are concerned about insulating your assets, a sole proprietorship or partnership may not be the best choice.
However, simply choosing to incorporate or form an LLC doesn’t guarantee liability protection. There are ways in which even a protected entity can lose its liability protection. Here are a few.
Piercing the Veil
To ensure your personal assets are protected, you must comply with various corporate regulations. In some cases, creditors may argue that the corporation is merely an extension of its owners rather than a separate business entity.
Along with making tax and incorporation fees in a timely manner, corporations must also hold yearly meetings and record their minutes for future reference. Additionally, corporations are required by law to form a board of directors. Failure to adhere to these rules is known as “piercing the corporate veil” and may result in owners being held liable for company debts.
Not all corporations are asked to comply with the same regulations. Taking these steps, however, can help show the IRS—and any creditors who may emerge—that your business is a fully established entity and not just a group of owners.
It’s no secret that small business owners are strapped for time. While you may be tempted to save precious minutes by using company funds for personal expenses or paying employee salaries out of your own account, these slip-ups can have a serious effect on your legal standing.
These slip-ups, known legally as “commingling assets,” can be a red flag for the IRS as well as creditors looking to seize your property to settle debts. To stay compliant, create distinct business accounts, and use them solely for company expenses. As an added benefit, by documenting business expenses separately, you can reduce the chances that the IRS will challenge your deductions come tax time.
Personal Service Liability
As discussed earlier, corporations typically provide liability protection for its owners. A variant of corporations are professional corporations (PCs), which apply to firms providing medical, legal and certain financial services.
This type of business entity enshrines liability protections for these professionals, but it also carries a personal service liability exception. Under this exception, a client who believes their care was negligent could seek damages directly from the owner in question. In this instance, a PC owner may also lose liability protection in the event that he or she injures a party personally and directly; however, any partners who also have ownership in the PC but are not involved with the incident will not lose their liability protection.
Starting a business can be a costly endeavor, and many entrepreneurs seek financial assistance from the Small Business Administration and other lenders. However, it’s important to note that liability protection may vanish in cases when owners default on personal guarantees.
Personal guarantees are unsecured written promises that are not tied to specific assets. However, in cases when a business owner defaults on payment, the lender can seize personal assets to satisfy the outstanding debt as well as default interest, legal costs and other fees. For this reason, entrepreneurs should be careful about signing personal guarantees and seek out alternative financing methods where possible.
Individual Partner Exception
Limited liability partnerships (LLPs) are business structures in which the partnership as a whole assumes liability while the individual partners remain protected, but only to a certain extent. As a result, partners can share in business activities without opening themselves up to liability for the acts of others. Because LLPs are limited to certain professions, such as law or accounting firms, they aren’t an appropriate choice for all business types.
While LLPs offer a number of advantages, it’s important that prospective partners realize the limitations of their protection, both individually and collectively. For example, a partner who takes out a loan for the business can be liable if the LLP defaults on payment. Furthermore, the owners will endure unlimited personal liability in cases when an employee of the company injures a party while operating on behalf of the LLP.
Protect Your Assets
The fact is that no single business structure protects its owners from all types of liability. Understanding the liability implications of each structure, however, can help protect your business from lawsuits in the coming years. Do your research to avoid putting either your personal assets or your business in jeopardy.
For more tips on protecting your assets, see our article on how to keep your personal assets separate from your business assets.