Fact checked for accuracy by Janet Berry-Johnson, CPA.
If you’ve heard about the need to set up a new business entity, then it’s likely you’ve heard about limited liability.
Someone may have mentioned it at a conference, for instance, and told you that it’s important to protect your personal assets in case your business ever gets sued or can’t meet its financial obligations.
You’ve received good advice.
Here’s the challenge: it’s not as simple as the blanket statement, “you benefit from limited liability when setting up a business entity”.
Setting up a limited liability company or a corporation as your business structure comes with a need to understand what protects your assets, as well as what can cause you to lose that liability protection.
In this article, you’ll learn all the important aspects of limited liability. With that knowledge, you should feel more confident about setting up a corporate entity and using it with your business.
What is Limited Liability?
Limited liability is a form of legal protection afforded shareholders and owners of publicly and privately-owned companies. A shareholder’s financial liability related to the company’s debts and other obligations remains limited to their personal shareholdings. Their personal assets stay protected even if the company itself gets sued or goes bankrupt.
The same holds for a business owner. They possess limited liability when they aren’t held personally responsible for the debts and obligations of the company.
One of the biggest reasons business owners decide to set up corporate structures such as limited liability companies or corporations is because of the limited liability they enjoy. If something happens where the company can’t pay its debts or gets sued by a customer, then the owners don’t risk losing their personal homes or vehicles.
It’s the legal separation that exists between a corporate entity and you that creates the limited liability scenario.
What Isn’t Covered by Limited Liability?
Don’t make the mistake of thinking that the limited liability afforded by setting up a business entity is a failsafe way to experience no penalty at all.
You can’t act recklessly inside your business and expect protection from the usual consequences that might occur. For instance, you can’t commit sexual offenses against others and expect liability protection. The same goes for causing an auto accident while running the business or using a personal guarantee when signing off on loans.
The IRS doesn’t recognize limited liability either. If you owe business taxes and can’t pay them down, the IRS will quickly identify your assets it can seize as part of your payment plan.
How You Can Lose Limited Liability
You’ll often hear limited liability protection called the corporate veil. If you lose limited liability status, then that means the corporate veil gets pierced. The piercing happens when a court decides to revoke your company’s limited liability and exposes your assets to creditors or other litigants.
You must understand the actions that can lead to the piercing of your company’s corporate veil. Here are the reasons that can cause it.
You can’t break the law and use limited liability as an excuse or expect it to save you from the consequences. If you or another company officer commits fraud, for example, then it’s highly likely that a court will pierce the corporate veil and expose your personal assets to seizure.
A court could also hold you personally responsible if one of your employees commits a criminal act. This possibility might happen if an employee kills someone while driving negligently in the company vehicle or commits sexual harassment.
The corporate veil doesn’t exist to protect a business or its officers and employees from acting so irresponsible as to break laws.
Commingling Company Funds with Personal Funds
You must maintain separate business financial accounts to maintain the corporate veil. For example, you need to set up a checking account for your company and use it exclusively for company expenses. If you pay your home’s mortgage with the business checking account, then you’ve commingled business and personal funds.
That’s a misuse of company funds. A court will look at that as a sign that the company operates the same as the owner. Without a clear distinction between the corporate entity and you, a judge will likely expose your personal assets to forfeiture during a lawsuit.
Read our article on how to pay yourself from your LLC for tips on keeping company funds and personal funds separate.
Providing a personal guarantee on a bank loan will pierce the corporate veil and remove your rights to limited liability. If your company ends up defaulting on the loan, then you’re held personally responsible for paying the money back. In these scenarios, you’re now at risk of losing your personal vehicles or home if you lack the cash to pay.
Keep in mind that providing personal guarantees while conducting business might be an unavoidable act.
It’s common for banks to require new businesses to use an owner’s personal guarantee because the company doesn’t yet have collateral. Make sure you go into such a situation with a complete understanding that you’re releasing standard limited liability rules. Don’t use a personal guarantee on any loans you believe to be too risky.
Don’t provide personal guarantees on any company contracts either. Always sign business contracts with your name and company title so that it’s clear you’re signing as a company officer. This understanding helps keep limited liability intact.
Conflict of Interest
Courts will pierce the corporate veil if you abuse fiduciary responsibilities and allow the business to profit you personally during any conflict of interest situations.
Conflict of interest occurs, for example, if your company (ABC company) hires another company (Company XYZ) that you or another officer also owns. If it’s proven that Company XYZ wasn’t qualified and unduly benefited you or the other officer, then a court can pierce the corporate veil. As a result, your personal assets are now exposed to liability.
How to Maintain Limited Liability
Don’t become alarmed about all the ways you could lose liability protection. It’s relatively simple to maintain the corporate veil and keep your personal assets free from legal exposure.
Step 1: Form an LLC
Don’t operate as a sole proprietorship, for instance. Take the first step toward enjoying limited liability by forming a limited liability company. Pay attention to the rules and regulations set forth by your state when it comes to LLCs. If you structure your business correctly via an LLC, then you’re halfway home when it comes to keeping business and personal assets separated. You can use an LLC service to get started.
Step 2: Follow Ongoing State Requirements
Each state has LLC requirements that you must follow each year. Your state might require you to file an annual report and pay a nominal yearly fee to keep the LLC in active status. It may ask you to maintain a permit or license. You’ll need to hold annual meetings and keep a record of each session. Doing these simple steps keep you in compliance and carry limited liability.
Related column: Corporate records management
Step 3: Don’t Commingle Personal and Business Roles
Never sign company contracts or documents without listing your company title. Signing with your name only makes it clear that you’re operating on behalf of your company. Doing so won’t look good in court if you need to prove that your business isn’t simply an extension of you.
Step 4: Don’t Commingle Personal and Business Funds
Never pay for personal items with your company’s checking account or LLC credit card. You also need to stay responsible when it comes to the business and its funds. Don’t take on business debt you know the company can’t handle. This type of financial irresponsibility can cause you to lose limited liability if you’re sued for financial negligence.
Types of Businesses with Limited Liability Protection
Three main business entities enjoy limited liability:
Limited Liability Partnership
Inside a general partnership, the owners remain personally liable for the company’s obligations. However, the partners gain limited liability when forming a limited liability partnership. Different states have varying rules around this, though, where partners enjoy less limited liability in some states than others.
A corporation’s officers enjoy limited liability because a corporation is an entirely separate entity from its owners.
Limited Liability Company (LLC)
Members of an LLC also enjoy limited liability. Again, the key is to pay attention to the previous section’s tips about maintaining limited liability.
It’s important to note that anyone operating as a sole proprietorship doesn’t get limited liability protection.
The law doesn’t recognize any separation between a sole proprietor and their business. In the eyes of the law, you and your business are the same. You should form an LLC as quickly as possible if you’re operating as a sole proprietor and are concerned about a lack of limited liability.
The Last Word
Are you excited to learn that you can separate your business activities from your personal activities and enjoy limited liability? If so, then your next action step is to structure your business correctly as an LLC.
Don’t wait until something can happen that causes you to wish you had acted sooner on your limited liability knowledge. Get started today and talk with your accountant or lawyer on the best way to keep yourself protected.
Filed under: Advice Columns