A limited liability company, also called an LLC, is one of the most popular business entities, as discussed in our article Choosing the Right Business Structure. LLCs are relatively easy to set up and provide business owners with the flexibility to choose how to operate and file taxes. Most importantly, they are perceived to protect business owners from business debts and legal claims. Our clients often ask us whether an LLC will really safeguard their personal assets from business debts. We will delve into the limitations of limited liability companies and the protections it does and does not provide its owners.
What Is an LLC?
An LLC is a legal entity with one or multiple members who may or may not participate in the active management of the LLC. LLCs are formed by filing registration paperwork with a state. Most states do not restrict the type of owners an LLC can have. Therefore, members can include individuals, corporations, other LLCs, or foreign entities. However, many states do not allow banks or insurance companies to organize as LLCs. For tax purposes, a single-member LLC is treated as a disregarded entity. For this reason, its activities are reflected on the owner’s federal tax return. Or the LLC can instead elect to file taxes as a corporation or S corporation. An LLC with two or more members can file taxes as a partnership or elect to file as a corporation or S corporation.
The state paperwork to set up an LLC is generally less cumbersome than that required of a corporation. However, like a corporation, an LLC is a distinct legal entity. Consequently, it protects its owners by separating their personal assets from the assets and liabilities of the business. This separation is often referred to as the “corporate veil.”
Limitations of Limited Liability Companies
There are certain events that can “pierce the corporate veil” and disrupt the protective barrier provided by an LLC. Some examples include:
Personal Guarantee on Business Debt:
A business owner who signs a personal guarantee for a business debt is now personally liable for that debt. If the business were to default on debt payments, the creditor could pursue the owner to collect. It is not uncommon for lenders to require a personal guarantee to extend debt to newer businesses.
Fraudulent or Willfully Negligent Acts:
An owner that acts in a fraudulent or willfully negligent way can be found personally liable for the consequences.
Co-mingling Business and Personal Finances:
If the business fails to keep its finances separate from the owners’ finances, this can also pierce the corporate veil. An example would be using a business bank account to pay for personal expenses or vice versa.
Failing to Accurately Capitalize the Business:
Setting up an LLC with insufficient capital to cover its liabilities and business operations may add to the argument that the corporate veil was pierced. This includes situations in which LLC members use their personal bank accounts to directly finance business operations.
Failing to Operate Like an LLC:
Unlike for corporations, only a few states and jurisdictions require LLCs to observe certain corporate formalities. However, many bank and investors require LLCs to have an operating agreement. An operating agreement outlines the purpose for which the business was formed, the roles of members, and other details of how the business will operate. If the LLC fails to follow the formalities required by their state, jurisdiction, or outlined in its operating agreement, this may add to the argument that the corporate veil was pierced.
In addition, failing to clearly operate as an LLC rather than under the identity of its owners can pierce the corporate veil. An example would be requesting payment on invoices be made out to an owner’s name rather than the LLC name.
How to Protect Yourself From Limitations of Limited Liability Companies
The first line of defense against personal liability is to avoid situations that obscure the line between the LLC and its owners. Owners should follow corporate formalities and scrutinize all contracts and loan agreements to determine if they contain clauses imposing personal liability. Avoiding these situations can help protect owners from personal liability. However, this can be challenging to do so without fail during the busy hustle and bustle of operating a business. Liability insurance can provide an additional layer of security against third-party claims made against the business. Professional liability insurance can, for example, pay out a portion or all of a financial judgment brought against a business owner if the party suing the LLC wins a lawsuit. There are various other types of insurance coverage that can protect owners against different risks as well.
Is an LLC right for you?
Despite the limitations discussed here, an LLC still offers a great deal of protection for its owners. Further, it generally requires significantly less time and money to set up. If you are a business owner debating whether an LLC is right for you, our team at My CPA is ready to help. Contact us today!