When the owner of an LLC has no business or money, creditors might attempt to collect outstanding debts directly from the small business owner. Are you protected from personal liability? Have you taken steps to ensure your LLC is structured to properly shield you from any personal liability for business debts?
The COVID-19 pandemic wrought devastation on virtually all sectors of the economy, especially small business owners. The shelter-in-place orders in effect across the country effectively halted any cash from flowing to small businesses. As a result, the owners of these small businesses no longer had the funds necessary to service loans, pay rent, pay utility bills, etc.
When a business owner falls behind on their bills, there is a risk that creditors could attempt to collect personally from the business owner. However, if the business is structured as a limited liability company (LLC), then you may have a proverbial shield from being held personally liable for business debts. Nevertheless, simply forming an LLC is not a panacea from personal liability. There are certain actions you need to take to ensure you are protected.
What exactly is a limited liability company?
An LLC is a limited liability business entity that is inherently designed to protect the owners of the LLC. In fact, one of the primary reasons people decide to form an LLC is to limit any exposure to personal liability for business debts.
When an LLC is established, only the LLC is liable for the debts and liabilities incurred by the business. However, the liability shield inherent with the LLC entity is not impenetrable. In fact, there are instances when an LLC owner can be held liable for the debts of the business.
Liability risks for LLC owners
These are some examples of the types of liabilities you could be exposed to when you form an LLC.
- Being held personally liable for the debts of your business
- Being held personally liable for the actions and debts incurred by any co-owners of the LLC or employees
- Being held personal liable for your own actions associated with the business
How you could be held personally liable for LLC debts
There are specific instances where the liability protection offered through an LLC can be penetrated and you are left exposed to personal liability for business debts. A common example is when you personally guarantee a business loan, small business credit card or other form of credit for your LLC. Basically, the personal guarantee means that if your business fails, you are guaranteeing that the loan or credit line will be repaid.
Another example is the risk of being held personally liable for any wrongdoings you committed while operating the business. If, let's say, the owners of an LLC failed to properly deposit taxes that were withheld from an employee's wages, the owners could be held personally liable for this offense. Another scenario is when the owners of an LLC intentionally engage in fraudulent or illegal conduct during the course of business that harms someone else.
How creditors can "pierce" the corporate veil to hold you personally liable for business debts
There are instances where the liability shield of an LLC could potentially be pierced by a creditor and the individuals associated with the LLC are thus personally responsible for certain outstanding debts. The “piercing” of an LLC's liability protection is commonly referred to as "piercing the corporate veil" by attorneys.
It is important to understand the factors that could lead to a creditor attempting to pierce the corporate veil of your small business so you can effectively protect your personal assets. The veil of liability protection afforded by an LLC could potentially be pierced in the following scenarios:
- If there is evidence that you are running the business as a mere “alter ego" of yourself. For example, if business funds have been commingled with your personal funds and there is no actual governance of the business aside from your personal dealings, then a creditor could pierce the corporate veil.
- If there is evidence that the owners of a business have been using the entity to perpetrate a fraud on others. For example, if someone runs a business as a corporation and the corporation is sued, it is not possible to transfer all corporate assets into a new corporation in an attempt to circumvent liability. In this situation, a court would view the new business as a fraudulent entity and pierce the corporate veil.
- If there is evidence that you formed an LLC solely to commit an illegal act or engage in illegal activities, then the corporate veil could be pierced.
| Activities and Actions of LLC Owner | Risk that Corporate Veil will be Pierced |
|---|---|
| Deposits business funds into their personal checking account | ✘ |
| Adheres to the specific terms of the LLC operating agreement | |
| Fails to properly capitalize the business | ✘ |
| Ensure that there is an annual audit of business finances |
Actions you can take to ensure your LLC provides sufficient liability protection
There are certain actions you can take to strengthen and fortify the liability shield that comes with an LLC. These actions include the following:
- Maintain and respect corporate formalities. This means adhering to the operating agreement of your business, including meeting schedules, record keeping obligations, etc.
- Never commingle business assets with personal assets. Make sure you have a separate checking account for the business that is distinct from your personal checking account.
- Ensure there is consistent and accurate accounting of the finances of your business.
- Make sure you sufficiently capitalize your business. Please be advised that there is no specific required amount or magic number. Instead, you need to review your company's finances and business operations to determine what is needed for proper capitalization.
- Ensure distributions are paid to LLC members and other holders of economic rights, in accordance with the terms of your LLC's operating agreement.
Consider purchasing business insurance
In addition to the actions described above, you should also consider purchasing liability insurance as an extra layer of protection from being held personally liable for business debts. A liability insurance policy typically protects you from certain risks your business may encounter, such as accidents and certain lawsuits.
Speak to a professional
When formed and managed properly, an LLC can help shield you from being held responsible for the debts of the business. But, as we discussed, your liability shield needs to be fortified and strengthen through proactive steps and effective corporate governance. If you have questions on how to properly structure your LLC, speak to an experienced professional in your area.