There are many advantages of a small business LLC. One is limited liability of members. Who wants to be personally liable for the debts of a sole proprietorship or partnership? LLC members and partners aren’t personally liable for the debts of the business, and that’s why many join in the first place. That means if the LLC can’t pay the bills, the members are safe. Sure, they might lose their investment in the business, but their personal assets are off-limits to creditors. That sounds great in theory. But is it true? Many partners and members find out the hard way that this isn’t always the case.
How can partners and members become personally liable for claims and debts of the LLC?
There are basically four ways for this to happen:
- If a member or partner does something involving negligence, fraud or some other illegal act which creates a third party claim – each member is on the hook
- If the partner or member personally guarantees a contract and claims are made
- The dreaded “piercing the veil” of the LLC (more on this later)
- Your LLC has an operating agreement and it spells out how and when distributions are made. If you get a distribution or consent to a distribution that violates this operating agreement, you can be personally liable.
Keep in mind that these exceptions for personal liability have really nothing to do with the LLC formation. You could find yourself in the cross hairs of a creditor for these violations if you were a corporation too. So if you are deciding between structuring your business as an LLC or sole proprietor, for example, it may not make a difference if you violate one of the four rules above.
If you are an LLC member or partner and you are an active part of the business, you are at risk for personal liability. For example, if you are a dentist and pull out the wrong tooth, you are going to be in trouble regardless of the kind of business entity you have.
And if you lie about your service or product, you have breached your contract with your client on behalf of the LLC. If the business can’t pay for the loss, guess who’s next in line? You are, and so are all the other partners and members. And if you hire someone who makes similar mistakes, your assets are on the line too. This goes for taxes too of course. For example, if one member doesn’t pay payroll taxes, all members are liable.
Claims Based on Contract
Looking for more ways to land in hot water?
You can assume personal liability by making a personal guarantee. If you launch a new small business, you may not have a choice. Many creditors will require you to make personal guarantees as a condition of making the loan.
Even if you don’t expressly accept personal liability, you might do this inadvertently. How? Well, if you sign a contract and don’t expressly do so on behalf of the LLC, the courts will probably decide you meant to sign the contract as an individual, and as a result, you’ll be the proud personal owner of all personal liability. Lovely.
The takeaway? Make sure that when you sign a contract on behalf of the partnership, you duly note that on the contract itself. Under your name, simply indicate your role as member or manager of the partnership.
You’re not done yet.
There are countless additional ways to take on personal liability.
I mentioned that “piercing the LLC veil” was a problem. This is something that a creditor may do, but only if she takes you to court. The court will look at a concept called “unity of interest” to determine whether or not you as an individual have a separate identity from the partnership. If there is no longer any differentiation, the courts will rule against you.
How do you help your creditors pierce the veil? Commingle your personal and business assets and you’ve done your creditors job for them. How can you guard yourself against your creditors’ piercing the veil? Here are a few important ways to safeguard yourself:
1. Keep your private and business assets (including bank accounts) separate.
2. Make sure your business has enough working capital. If you constantly underwrite the business with your personal funds, the creditor can easily prove there is no distinction between you and your LLC.
Be careful about distributions.
The Revised Uniform Limited Liability Company Act expressly prohibits distributions if by making such distributions your LLC becomes insolvent. For example, let’s say your small business liabilities pile up. You decide to distribute all the cash and assets and then declare bankruptcy to stick it to your creditors. If you take that action, the courts will find that your creditors can go after you personally because you’ve taken down the wall.
And it gets worse. Let’s say you have partners and you agree, nice gal that you are, to make distributions without knowing that by doing so, the LLC will become insolvent. Just by consenting to these distributions you’re as liable as the member who actually makes the distributions.
With all these limitations, is there really any limited liability in LLC’s?
Yes. While these caveats may seem overwhelming, for most day-to-day issues, the LLC can be an excellent way to do business. The LLC has many tax advantages and it really does provide limited liability.
The best example is if you have employees. If they mess up and or act with negligence or even fraud, the LLC should protect you from personal liability. Or if you sell a product or service with good intent but, unbeknownst to you is defective, you’re personal liability is protected.
If your personal liability is important to you, there are several steps you can take.
- Business Insurance. Make sure you have the proper liability insurance for small business. It won’t impact your personal liability, but it may provide the assets to pay claims.
- Never make personal guarantees. Even if a creditor requests that you do so, negotiate hard on this and perhaps you can get the creditor to waive the requirement.
- Small business working capital. Make sure you don’t have to continue to stream money from your personal assets to the business. When you do invest in your LLC, document it fully.
- Separate the assets. Don’t commingle assets or business and personal bank accounts.
In addition, I would be very careful about how you choose to do business with – and that includes your partners. At the very least, before you form an LLC with someone else, make sure to check their credit score. Be certain you deal with reputable people.
No matter how big or small your business is, it should have its own business bank accounts. Don’t pay personal bills from the business. If you need some extra cash to pay personal bills, take a draw, deposit that money in your personal account and pay the bills.
If you take a few important steps and don’t play around with funny business, the LLC will remain intact and provide you with personal asset protection that other small business structures can’t come close to.
financial knowledge online says
So, from what I just read, a general rule of thumb is to treat your LLC like a business (different accounts and identity) and make sure that the cash flow is coming from operations instead of your personal bank account.
Great article. You sound like you know a lot about LLCs and liability. Are you a lawyer?