Forming a limited liability company is an important first step in protecting your personal assets from being used to pay business creditors.
Understanding an LLC’s Limited Liability Protection
When you form an LLC, you establish a new business entity that’s legally separate from its owners. This separation provides what is called limited liability protection.
As a general rule, if the LLC can’t pay its debts, the LLC’s creditors can go after the LLC’s bank account and other assets. The owners’ personal assets such as cars, homes and bank accounts are safe. An LLC owner only risks the amount of money he or she has invested in the business.
But, as with most things, there are exceptions.
Owners are still liable for debts that they have personally guaranteed. They may be liable for unpaid payroll taxes. And they are liable if they are sued for their own wrongdoing.
Even with these limitations, liability protection is a valuable feature of LLCs and plays an important part in your asset protection strategies. Here are some tips to get the most out of it.
Obtain LLC Insurance
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.
For this reason, it is important to have a good liability insurance policy that will cover both you and your business if you get sued.
Maintain Your LLC as an Independent Entity
In corporate law, shareholders who mix personal assets with corporate assets can sometimes be held personally liable as the “alter ego” of the corporation. There are indications that courts may also extend this sort of liability to owners of LLCs.
To avoid any chance of alter ego liability, it is important to keep LLC records and finances completely separate from the owners’ personal finances. The LLC should have its own bank account and credit cards. Contracts, invoices, purchase orders and other important documents should always have the LLC name on them and should be signed on behalf of the LLC.
That way, everyone you do business with will know that they are dealing with an independent entity and not you personally.
Establish LLC Credit
Personal guarantees are a major reason why small business owners become liable for company obligations. If you personally guarantee a lease or a loan, you agree to make payments if the LLC cannot.
In some cases, you may be asked to pledge your home or another large asset as collateral for a business loan. If the LLC defaults on the obligation, the creditor may go after your personal assets to satisfy the debt.
If your business is new, it’s likely you’ll have to personally guarantee large transactions. But you may be able to avoid some guarantees in the future by establishing credit in your LLC’s name, paying your bills on time, and showing a track record of revenue and profit.
Keep “Just Enough” Money in the Company
If your LLC is sued, the money that is in the LLC can be used to satisfy a creditor, but your personal assets usually cannot. To limit your vulnerability, it makes sense to keep as little money as possible in the company and pay the rest to the owners.
There are a couple of important limitations on this, however. If you already owe a creditor and transfer money out of the company, the transaction may be regarded as a fraudulent transfer. And if you don’t keep enough money in the company to meet its expenses, a court may hold you personally liable on an alter ego theory for undercapitalizing your business in an effort to defraud business creditors.
Explore Strategies to Protect Assets from Personal Creditors
As noted, your personal assets can still be at risk for LLC obligations if you are sued for personal wrongdoing or as a result of a personal guarantee. Depending on the state where you live, there may be ways to protect some or all of your personal assets from these types of claims.
In some states, you can put assets into a trust that is protected from creditors, though you must typically do this years before there are actual unpaid debts or judgments. Certain property, such as your primary residence and money in retirement accounts, may be automatically protected from creditors.
You can consult with an estate planning and/or bankruptcy attorney to determine whether you can structure your assets in a way that will further shield you from liability for business obligations.
Asset protection LLC strategies such as keeping business and personal finances separate and maintaining proper insurance can help keep your personal assets safe from business creditors. Although there’s no such thing as 100 percent protection, advance planning can help reduce your risk.