Forming a Limited Liability Company (LLC) has definite advantages for many sole proprietorships and partnerships. But, the word, limited is there for a reason. It is not the same as having a get-out-of-jail-free card.
As with all business formation decisions, your eyes need to be wide open to the underlying principles behind LLCs. Understanding the contextual meaning of Limited is a good starting point.
The Difference Between Personal and Company Liability
Forming an LLC does not remove liability, so much as it transfers certain liability issues from owners to the business. This is good news for business owners who do not want to risk their personal assets to lawsuits and other potential legal issues that can easily arise in the course of business. However, there is a definite type of dividing line when it comes to issues pertaining to personal versus company liability. Here are the key concepts that can help you identify times when your personal assets could still be at risk.
LLCs do not protect individuals from personal liability
Any company can be responsible for harm sustained by employees and third parties when they are caused by just about any type of company operations. They must carry Workers’ Compensation insurance to protect employees, and liability (casualty) insurance is still important to protect against harm or injuries to others.
But, an LLC owner who hoists a few beers at a business lunch before getting into a company or personal vehicle and causing an accident is still personally liable for all damages — not to mention potentially criminally-liable — even if the accident occurs during business hours or while conducting company business.
Separation of personal and business matters is essential
An LLC might face legal action for unpaid bills or failure to meet other legal obligations, but LLC members can rest more easily knowing that their personal assets are safe from lawsuits. Questions of personal liability can arise, however, when owners have a habit of paying bills out of their personal accounts or personally guarantee business debt.
In cases like these, judges might find that the business does not meet the legal requirements for LLCs even if the company is properly registered. Once LLC status is invalidated, the courts can easily find one or more members to be personally liable.
LLC members can face individual criminal prosecution
LLC members receive no liability protections when they perform illegal or fraudulent acts. A common example of this would be when members withhold taxes from employee wages and fail to deposit them in accordance with IRS requirements. Other white collar crimes, such as embezzlement, insurance fraud and money laundering (to name just a few), are also subject to personal prosecution, often in the federal criminal court system.
LLCs might have indirect responsibility for an owner’s personal debt
At the opposite end of the coin, do not automatically assume that an owner’s default on personal debt cannot adversely affect an LLC. Granted, creditors cannot go directly after the assets of LLC per se to pursue repayment of an owner’s personal debt. Still, keep in mind that each LLC member owns a percentage of the business, and some states permit various remedies related to that ownership.
In these states, judges can issue charging orders, which essentially place a lien against a debtor LLC member. While these orders protect other members from liability, they allow creditors to collect the distributions and assets that the LLC would normally allocate to the member. In some cases, creditors can foreclose on the debtor member’s ownership interest in the LLC, essentially creating an unexpected partner replacement. Or, they might even get a court order to dissolve the LLC.
Three Ways to Protect LLC Status
LLC members need to take an organized, disciplined approach to their overall business practices. The following common-sense practices can go a long way toward protecting liability concerns:
- Keep personal business away from business transactions: It’s common for young businesses to experience occasional cash flow challenges. It’s equally common for business owners to chip in from personal funds or personally guarantee business loans to assist with temporary business liquidity deficits.. This type of practice muddies the waters when liability issues arise. Keep personal checkbooks and credit cards at home, and avoid signing legal documents as anything other than an authorized officer of the company.
- Learn the laws in your state of LLC formation: If you formed your LLC in your home state, it’s called a domestic LLC. If it’s formed out of state, it becomes a foreign LLC. Either way, the state of formation has specific regulations that govern the underlying rules that your company needs to follow to retain its LLC status. Knowing and following these rules can help reduce the chances of personal liability.
- Develop an LLC Operating Agreement: Not all states require LLCs to develop Operating Agreements, but any court might find such an agreement to be compelling evidence of limited liability status. Since LLC Operating Agreements provide other benefits, such as potentially enabling businesses to follow their own rules rather than the rules of the state, the effort of developing one is worthwhile.
Choosing the Right Level of Legal Support When Forming an LLC
Even though LLC formation seems relatively straightforward, it is a major decision that involves taking the proper steps — after deciding which state offers the choices that work best for your particular business. Keep in mind that it’s not typically easy to dissolve the LLC if you later learn that you made unwise choices.
It’s hard to beat the customized assistance provided by a trusted business attorney, but if you’re willing to take the time to examine the laws of the state of formation, you might want to consider a do-it-yourself approach. Nolo.com is a good example of a website that provides a wealth of resources for this purpose.