Think Incorporating Will Protect Your Personal Assets? Not in These Cases. Although you should definitely seek legal status for your business, these 6 scenarios could cost you big.
By Nellie Akalp Edited by Dan Bova
Opinions expressed by Entrepreneur contributors are their own.
For the savvy entrepreneur, incorporating a business can be a great way to lower the tax bill, ensure the business lives on, and gain legitimacy as an established business. However, the number-one reason to incorporate or form an LLC (limited liability company) is to protect any personal assets from the liability of the business.
Separating the personal from the business makes a huge difference. After all, who wants their hard-earned savings or child's college fund wiped out due to some unforeseen trouble with a business venture? If you aren't personally liable for your business' debts, there's a lot less to worry about since creditors can only go after the bank account and assets of the business. When you're personally liable, there's obviously a lot more at stake.
While an LLC or corporation puts a barrier between the finances of the owner(s) and the business, filing this paperwork isn't going to give you 100 percent immunity. There are several circumstances where you can still be personally liable for what happens in your corporation or LLC. Understanding these situations will help you sleep better at night and keep your personal assets safe for years to come.
Related: Incorporating? Avoid these 5 Mistakes
Here are some of the situations where you will be personally liable for what happens in your corporation or LLC:
1. You personally guarantee a loan for your business. Owners of young or small businesses are often asked to personally guarantee any bank loan, rental application or supplier relationship until the business itself builds its own credit. When you sign a personal guarantee for a loan, lease or contract, you're saying that you will personally pay back the loan if the business fails to. Essentially, this act gives up your limited liability for the debt -- and if your business can't pay back the loan or make its rental payments, you will be personally on the hook for it all.
Whenever possible, avoid signing a personal guarantee for your business contracts (such as a loan for a business vehicle, a bank line of credit or a commercial lease). Of course, there will be times where a personal guarantee is necessary to keep your business moving. In these cases, just be aware that you've given up your limited liability for this particular debt.
2. You sign a contract in your own name. While the situation above may be unavoidable in certain situations, many times business owners give up their limited liability out of sheer carelessness. It's imperative to check how you sign any purchase agreements and business contracts. Are you signing them as an individual or a representative of the business? There's a big difference.
For example, if you sign a contract as Jane Smith, you're personally liable for the associated debt. But, if you sign the contract as Jane Smith, CEO of Jane's Books, then only the business is liable. Take care whenever signing any contract and make sure to always sign your name in the capacity as an owner or officer of the business.
3. You use your own credit card to fund a purchase. For the small-business owner, personal and business finances are often closely intertwined. It may seem harmless enough to use your own credit card to pay for some new equipment or other business expense. However, keep in mind that whenever you use your own credit cards or take out a home equity loan, you are almost always personally liable for these debts. This can be true even if your business' name is on the credit card (you'll need to check the terms of the credit application you originally signed).
Related: The Biggest Legal Mistake Entrepreneurs Make
4. You commit a crime or misrepresent yourself. A corporation or LLC won't protect you if you break the law. Likewise, if you lied about any details on a loan or credit application for the business, you will most likely be personally liable for the debt.
5. Your actions injure someone. If you provide a service to a customer (you're a doctor, driver, consultant, tattoo artist, lawyer or accountant), you can be held personally liable for any claims of malpractice or negligence. For this reason, it's critical to take out a robust professional-liability insurance policy to protect against malpractice or negligence claims. If your business has a general liability policy, be sure to check if it will protect you against these types of claims, as most don't cover them.
6. You don't keep your LLC or corporation in compliance. An LLC or corporation needs to keep up with various formalities based on state law. These might include meeting minutes, an annual statement, articles of amendment and keeping your business and personal finances separate. If a creditor wants to sue your business, they'll often try to "pierce the corporate veil" by showing that the LLC or corporation didn't follow these necessary formalities. And if the judge agrees, you can be personally liable to pay that debt.
For this reason, it's critical to keep up with any of your recordkeeping and state filing needs for your business. Make sure to get your annual report to the state on time. Record any important decisions in your meeting minutes. Update the state with any major changes to the LLC/corporation (a change of address, new board members). And make sure to keep a sharp line between your personal and business finances.
The bottom line. Incorporating or forming an LLC is an essential first step toward minimizing your personal liability. But this step always needs to be followed by some common sense and an understanding of the law to best protect your personal savings and property.
