Setting up your business as a limited liability company (LLC) is a great option for many business owners since incorporating can help protect personal assets from business liabilities and enhance the legitimacy of your business. However, there are certain circumstances in which an LLC might not fully safeguard your assets.
In this article, we'll clarify these situations, recommend measures to avoid them, and help ensure your LLC functions as intended: as a shield between your personal and business assets.
Personally guaranteeing a business loan
If you personally guarantee a loan for your LLC, you essentially pledge your personal assets to secure the loan. Should the business default on its payments, the lender has the right to recover their losses from your personal assets.
One way to avoid this risk is by seeking alternative financing options that don't require a personal guarantee.
Building a robust credit history for your business can help increase a lender's confidence in lending directly to your LLC without requiring a personal guarantee. Start by ensuring your business has an Employer Identification Number (EIN). Obtain a DUNS number from Dun & Bradstreet, as lenders and creditors often use a company's credit report with Dun & Bradstreet when deciding whether to extend credit. Simultaneously, apply for a business credit card and make regular purchases for your business. Always pay the balance on time, as timely payments will contribute to your business credit history. Enhance your credit further by working with vendors that report your payment history to major credit bureaus.
Signing your name on a contract
If you sign a contract in your name instead of your LLC's, you may be personally liable for any breach of contract or related issues. This is because you, as an individual, instead of your LLC, became a party to the agreement.
To avoid this risk, always sign contracts in your official capacity in the name of your LLC. For example, if your LLC's name is "ABC, LLC," sign the contract as "ABC, LLC by John Doe, Chief Operating Officer" to clearly indicate you are signing as a representative of the business, not as an individual.
Mixing personal and business finances, such as using a personal credit card for business expenses, can lead to "piercing the corporate veil." This term refers to a legal situation where the courts see no separation between you and your LLC, making you personally liable for the LLC's debts.
This risk also extends to the use of business assets for personal purposes. For example, if you use your LLC's money or property to pay for personal expenses, this could potentially leave your personal assets exposed to business creditors.
Avoid this by strictly separating personal and business finances. Open a business bank account and credit card, and use these for all business-related transactions. Consistently document and categorize business expenditures to ensure clear financial delineation.
If your LLC does not have enough funds to meet its likely obligations, courts may view this as deliberate undercapitalization, which may be sufficient to pierce the corporate veil. Essentially, a court could conclude that the LLC is a sham entity set up to defraud creditors.
To mitigate this risk, ensure your LLC is adequately capitalized from the beginning. This involves contributing enough capital to the LLC to reasonably cover its foreseeable expenses and debts. What is considered "adequate" will vary depending on the type of business, its size, and its industry, but it should be enough to meet the business's anticipated liabilities. This also means you should continually monitor your LLC's financial health to ensure it remains adequately capitalized as it grows and evolves. An experienced accountant can help you determine what is appropriate for your specific situation.
Malpractice, negligence, or personal acts of wrongdoing
Certain professionals like doctors, lawyers, and others who are open to personal litigation can still be personally liable for malpractice or negligence claims, even if they conduct their business through an LLC. The LLC structure might not protect personal assets in cases where professional wrongdoing is claimed.
Likewise, your LLC cannot protect you from liability for your personal wrongdoing. If you personally harm someone while working for your LLC, you can be held liable. This is distinct from malpractice or negligence and could apply to any owner or employee of an LLC, regardless of profession or industry.
To help mitigate this risk, professionals should be covered with malpractice or professional liability insurance. Regular training and diligent adherence to industry standards and regulations can also help to reduce the risk of malpractice claims. For other LLC owners, you can reduce risks by operating your business responsibly and training your staff well. It's also worth considering comprehensive liability insurance.
If you transfer money or property out of the LLC when it is insolvent or do it with the intent to defraud, hinder, or delay a creditor, a court may reverse the transfer and could hold you personally liable for the amount of the fraudulent transfer.
To avoid this risk, always conduct transactions in good faith and refrain from making transfers if the company is insolvent. If you are unsure whether a transfer of money or property could be considered fraudulent, consult with a legal professional before making the transfer.
Noncompliance with corporate procedures
Failure to adhere to the required corporate formalities can jeopardize the LLC's liability protection. If you don't keep your LLC in compliance - for instance, if you fail to hold and document annual meetings in some jurisdictions or maintain proper financial records - courts may "pierce the corporate veil."
Maintain LLC compliance by regularly updating your business records, separating personal and business finances, and adhering to the statutory requirements of your LLC operating agreement and the laws of your state. Regular consultation with legal and financial professionals can ensure your business stays compliant.
While an LLC offers a strong layer of protection for your personal assets, it isn't a silver bullet. It's important to be diligent about maintaining separation between your business and personal affairs, operate lawfully and ethically, and consult with professionals to ensure you fully comply with your LLC's operational requirements.
This article is intended to provide a brief overview of situations where an LLC may not protect your personal assets and is not a substitute for speaking with one of our expert advisors. For more information, please contact our office.