An LLC may be costly to start, but a lawsuit would cost more.
A limited liability company (LLC) is the right structure for many businesses. It provides necessary protections for founders and partners while creating the right amount of flexibility for managing the business.
Protecting personal assets from business creditors is typically the prime motivation to go for an LLC. LegalZoom breaks it down this way: "If an LLC is forced into bankruptcy, then the members will not be usually required to pay the LLC's debts with their own money. If the assets of the LLC are not enough to [cover] the debts and liabilities, the creditors generally cannot look to the owners for payment. Their debt was with the LLC, not the people that owned the LLC."
An LLC creates a separate legal entity that bears the responsibility for its own legal obligations. The members are legally separated from the LLC itself. While they typically are not responsible for the LLC's obligations and debts, there could be exceptions.
LegalZoom outlines some of the concerns of asset protection strategies. For example, "If someone files a lawsuit accusing you of wrongdoing – whether it's negligently maintaining your building, wrecking the company van or defrauding a customer – your LLC won't protect you from personal liability. And the judgment in a personal injury lawsuit can be financially devastating."
NOLO recommends that those forming an LLC make sure to properly run the business as an independent entity. Running the organization as a bona fide independent business ensures that a court won't find you've mixed personal and business interests. Courts want to ensure a business is legitimate; otherwise, owners could be held personally responsible for certain liabilities or debts.
Ways to protect your assets with an LLC
LLC records and financials should be kept up to date. Invoices, purchase orders and other key financials shouldn't mingle with any personal finances. For anyone you do business with, it should be clear they are dealing with a separate entity from your personal engagements.
Appropriate levels of insurance are also critical. Business owners should assess their liabilities and risks and find the right level of liability protection. Your industry associations will be a good place to find recommendations for ensuring you have the right level of coverage. While the cost of premiums is one thing to consider, it pales in comparison to a costly lawsuit.
Situations where an LLC can't protect your assets
Although an LLC provides a barrier between your personal finances and the business finances, filing the paperwork doesn't provide you with 100% immunity. There are a number of circumstances in which you may still be personally liable for what happens in your LLC. Understanding these circumstances will help keep your personal assets safe. Situations where you will be personally liable for what happens in your LLC may include:
Personal guarantee for a business loan. As the owner of a small or new business, you may be asked to personally guarantee a bank loan, supplier relationship or rental application until your business itself has built up credit. Signing a personal guarantee for contracts, loans or leases, means that you are personally going to repay the loan if the business fails to do so. By doing this, you are basically giving up your limited liability for the debt, and if the business cannot pay back the loan or make the lease payments, you are personally responsible for it all. If at all possible, you should avoid signing a personal guarantee for any business contracts.
A contract is signed with your name. In many situations, this is the result of simple carelessness; however, if you sign a contract in your name instead of the business name or with the addition of your position, you may be personally liable for the cost of the contract. For example, if you sign a contract as John Smith, you are personally responsible for the debt associated with the contract, but if you sign the contract as John Smith, CEO of [Name of business], then the business is liable for the debt. For this reason, it is critical that you be aware of how you are signing your name to any business-related contract.
Using your personal credit card for business purchases. As a small and/or new business owner, your business and personal finances may overlap. Although it may seem OK to use a personal credit card to pay for equipment or other business expenses, you are always personally liable for the debt. This may even be the case if your business name is on the credit card. For instance, when signing the credit card application, if you sign your name, but the card is issued to the business.
- Misrepresenting yourself or committing a crime. An LLC will not protect you if you break the law or misrepresent yourself, e.g., if you weren't truthful about any of the details on a credit or loan application for the business. In this situation, you will generally be personally liable for the debt.
Forming an LLC is a critical first step toward reducing your personal liability; however, it's also important to use common sense and have an understanding of the law in order to protect your personal property and savings.
An LLC is often the best legal route for those wanting to establish a business with a good set of protections for their assets. Be sure to consult with the experts and determine if it has enough advantages over other business types to make the best move.