If you think forming an LLC, S-Corporation, or limited partnership means your personal assets are 100% safe, then think again.
The truth is, if your business gets into legal trouble, liability protection is a powerful tool, but there are exceptions and mistakes that can leave you personally on the hook. In today’s post, I’m diving into how liability protection works and what you can do right now to keep your business and personal finances out of danger.
Does “liability protection” mean I can’t be sued personally?
If you’ve taken the time and effort to set up your business as an LLC, S-Corporation, C-Corporation, or multi-member LLC, congrats! You’ve taken a big step in protecting yourself personally because as you know, these structures are designed to separate your personal assets from your business’s debts and liabilities.
However, that liability protection isn’t bulletproof. There are situations–some pretty common, actually–where you can be sued personally, meaning your personal assets might still be at risk. I’ll talk more about some of those in a minute.
However, an important distinction to make before we get into examples is the difference between being financially liable and being criminally liable:
- Financial liability means someone is trying to get money from you. This could be damages from a lawsuit, contract disputes, or unpaid debts.
- Criminal liability means that laws have been broken. This could be for things like tax fraud, environmental violations, or embezzlement, and the consequences can include both fines and incarceration.
There is no business structure that can protect you from criminal prosecution if you are found to be criminally liable.
In the tax world, this means that if you cook the books or hide income, the IRS isn’t going to stop at your business. They’ll come after you personally as well.
When can I still be sued personally even though my business entity provides liability protection?
Even though you may own an LLC or corporation, it’s important to be aware of these three common situations that may put you at risk of being held personally liable:
1. You personally guaranteed a loan.
If your business takes out a loan or enters into a lease agreement and you sign a personal guarantee on that loan or lease, then you will be held personally liable to repay if your business defaults on payments.
This happens often–especially with loans–because banks typically require that small businesses have a personal guarantee on any loans. This means that even if you own an LLC or S-Corporation, the bank may ask you to sign the loan twice (once as the business and once as an individual).
2. You were negligent or committed fraud.
Remember that when talking about business liability, we’re mainly talking about financial liability protection. This protection doesn’t extend to any personal wrongdoing. If you’re found to be personally negligent, acted in bad faith, or committed fraud, you can be held personally responsible. These actions include:
-
- Lying on loan applications
- Causing harm to someone due to careless actions
- Misrepresenting your business’ services or products
3. You didn’t separate your business and personal finances.
This is huge and something I stress when working with my clients. You should always set up a separate business account to avoid what’s called “commingling funds.”
If you don’t, and there’s a legal situation, the court can decide that your business isn’t legitimate. They can then “pierce the corporate veil,” which means that they will ignore your business structure entirely and can come straight for your personal assets if your business is found to be liable for any type of damages.
As a business owner, how can I protect myself from being sued personally?
To stay on the safe side, you should:
Use strong contracts.
Always have solid contracts in place with clients, vendors, employees, partners, and lenders. Make sure your contracts spell out expectations, responsibilities, and liabilities. Use an attorney to help write or review contracts whenever you have any questions or doubts.
Review your insurance policies.
Insurance–especially in some professions–can be a major consideration for your business’ finances and protecting its future. This can also be true if you want to fully protect your personal assets.
You should work with an insurance agent and speak to other business owners in your field to make sure that your business has a solid general liability policy.
Then, you should consider whether it would make sense to add an umbrella policy to cover acts, errors, and omissions. This is especially true if you’re in a profession with a higher risk for these types of lawsuits, like a real estate agent, financial advisor, or accountant.
Avoid personal guarantees when you can.
Your business can absolutely make a guarantee, and you can and should stand behind that guarantee by providing your best work, craftsmanship, or expertise. However, do not make guarantees–especially financial guarantees–that could come back on you personally.
Maintain proper paperwork and meetings.
Don’t just complete your LLC or S-Corporation filings and call it a day. Make sure you hold annual meetings, keep meeting minutes, review contracts and partnership agreements, and maintain clear, up-to-date, and accurate records and paperwork. Taking the time to follow these steps will help strengthen your liability shield.
If my business has multiple owners and one of us gets sued, how does that affect the other owners?
If your business has multiple owners and one of you gets sued personally–maybe over a personal debt or a divorce settlement–in most states, a creditor can’t just take over that person’s share of the business.
What will happen instead is that the court will issue what’s called a “charging order.” This order will allow the creditor to collect any debt they are owed by creating a lien on the debtor’s ownership share so that the creditor can collect that owner’s share of business distributions until the debt is paid.
However, a charging order doesn’t allow the collector to make management decisions, force the sale of the business, or directly access any of the business’ assets.
It’s important to note here that I said this is how things happen in most states. In some states, things get much trickier and the court or jurisdiction can do things that force the other partners to use the business money to shake free of the creditor. The bottom line is that you’ll absolutely want to consult an attorney if you find yourself in this type of situation.
Abridged by Amy
Setting up an LLC or S-Corporation can be a very smart financial move for your business, but it’s not a magic force field. These business structures can give you a solid foundation, but how you run your business and manage your risk is what really really protects you.
When in doubt, be sure to talk to an accountant who can review your structure, documents, and financials and determine the best next steps for your business’ success. If you’ve already done the hard work of building a business, it’s worth protecting it (and yourself!) the right way.
