Last Updated on August 29, 2020
What is an LLC?
A limited liability company (or LLC) is a business entity that can have a single owner or multiple LLC owners (referred to as “members”). The defining characteristic of this type of business structure is the personal liability protection it affords business owners. LLCs are considered separate legal entities from their members and will usually have a separate Employer Identification Number (like a social security number for an individual, but for a business). This means that creditors can only seek repayment for business debts from assets held by the LLC, rather than from the individual members. In particular circumstances, however, this protection may no longer shield members and their assets from personal liability.
Without officially filing formation documents, a business operated by a single owner is considered a sole proprietorship by default. The key distinction between a sole proprietorship and a single-member LLC is that the owner of a sole proprietorship retains individual responsibility for all the liabilities of the business. If your business has a judgment or other legal claim against it, you personally would be on the hook for payment as a sole proprietor. The same holds true as a partnership vs a multi-member LLC, but as a partnership, if one of the partners gets the business in trouble, each of the owner’s personal assets are at risk.
Related: How to form an LLC in each state.
How Does Having an LLC Protect You?
The best-known attribute of LLCs is the ability to protect your personal assets. Personal assets that are usually protected include personal bank accounts and other personal property such as houses and vehicles.
Operating as an LLC protects owners from personal liability for wrongdoing committed by other owners and employees in the ordinary course of business. In the event that a lawsuit is brought against the LLC for these wrongful actions, the LLC’s assets can be used to satisfy the judgment. Although the owners who did not act will not be personally liable, the responsible employee could be pursued for additional recovery from his personal assets.
It is important to note that any property or money contributed by members to the LLC is considered an asset of the company and can be used to repay business debts. Creditors may also be able to pursue legal action against the LLC that could require payment of profit distributions to the creditor rather than to the members until the obligation is repaid.
Another way the LLC protects you is the business is protected from a personal lawsuit. In a scenario where an individual operates their business as a sole proprietor, if the individual were sued personally, a creditor could seek a charging order and obtain repayment from business assets. With an LLC, it’s very difficult to get a charging order against an LLC. This is very beneficial when there are multiple members as a business owned as a partnership could risk losing the business due to a personal lawsuit from a partner.
What an LLC Cannot Protect You From
Your Own Bad Acts
A Limited Liability Company can’t protect you from individual liability for malpractice, negligence, or fraud that you have personally committed in your professional capacity. Hiding behind an LLC cannot shield you from the legal consequences for your bad acts. This gap in the protection from the LLC is the reason most small business owners opt to purchase personal liability or malpractice insurance. Furthermore, if you carelessly or maliciously act and the business loses money, the other members may pursue legal action against you individually to repay the losses incurred.
In the beginning stages of a business, many members may sign a personal guarantee for business loans, lines of credit, commercial leases, and other debts, even if the funds are designated solely for business purposes. Doing this opens members up to individual liability for those debts and obligations in their names.
If you sign a personal guarantee, you are voluntarily waiving your limited liability and giving permission to the creditor to pursue you personally for repayment. The same applies if you secure a business debt by offering your personal property as collateral to the lender. A lender could potentially file suit to foreclose on your property to repay your LLC’s debt.
In the same vein, signing contracts and agreements in your own name without referencing the business name and your official title can enable the other contracting party to pursue you individually for breach of contract. Carelessly signing your name to documents that display your personal information rather than the LLC’s name can result in your personally liable for obligations under the contract. This is true regardless of which party drafts the documents. For this reason, it is important to check the body of the contract as well as the signature block for your correct business title and company information prior to signing.
Can I Be Sued Personally If I Have an LLC?
Forming an LLC adds a layer of protection between your business and personal assets. However, there are certain instances when a court may decide that the individuals behind a company should be held accountable personally for the obligations of the LLC. In legal terms, this is referred to as “piercing the veil” because this essentially shatters the legal barrier between you and your business. If it appears that your business is not operating in good faith as a business, a court may determine that the legal entity is nothing more than your “alter ego” and not legitimate.
Am I Personally Liable for Debts if I Have an LLC?
As mentioned above, business owners can endanger their limited liability protection by signing contracts in their name or personal guarantees for debts, even if on behalf of the LLC.
Members are also likely to be held personally liable for any of the LLC’s federal tax obligations as well as debts for payroll taxes.
Related: How to sign on behalf of an LLC
Best Practices to Ensure Protection Under an LLC
Generally, the best way to avoid piercing the veil of your LLC is to observe formalities that reinforce your business as a legitimate enterprise. The first step is to make sure you have an operating agreement in place, even if you are the sole LLC owner. An operating agreement is an internal document that describes the basic structure and operations of the business. Another important function of this agreement is to outline procedures to be followed upon certain occurrences throughout the life of the LLC, such as a member leaving or adding a new LLC member. Having an operating agreement demonstrates an effort to systematically run and operate as a real business. If legal action is brought against your business, your operating agreement will serve as evidence that you comply with common LLC formalities.
Another way to separate your business activities from your personal affairs is to be sure to sign all business-related documents on behalf of the LLC with your official business title. This includes taking the added steps to endorse company checks with your title underneath your signature and signing checks for payment in the same way.
In the same way, it is important to keep your personal finances separate from your company’s. This means you should have a separate bank account designated solely for your business as well as any loans and credit cards for your business in the LLC’s name. Commingling funds may risk the business’s liability protection.
Last, limited liability protection is no substitute for liability insurance. Even having the business liability protection the LLC provides, business insurance should be obtained to protect the company from a variety of risks. Every business has different insurance needs, so be sure to have the business covered.