The Kentucky Small Business Law Blog seeks to provide original content, news and information regarding legal issues facing small businesses in Kentucky.

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Friday, September 10, 2010

Fact or Fiction? Setting Up A Corporation Or Limited Liability Company Protects My Personal Assets.

“I want to set up a corporation or limited liability company because my spouse wants to make sure we don’t lose our home if the business goes under.”

This, or a similar statement, is often made by a first time business owner who is finally pursuing their dream of owning their own business. When I hear this, I give what I call my good news/bad news speech.

The Good News.

From a purely legal standpoint, a corporate or limited liability structure is designed to protect the shareholder or member from personal liability from claims by third parties.

The Bad News.

As a practical matter this protection has limitations.

First, if you need to borrow money, the bank will require that you sign personal guarantees and pledge personal assets such as that home you want to protect, as collateral. In addition, if you are going to lease space or buy supplies on credit, most large companies and many smaller companies will require a personal guarantee before approving the lease or setting up the account. So, if your business goes under and your company files bankruptcy or just closes the doors, the company’s creditors, to whom you have pledged collateral or have given guarantees, can pursue you personally.

In addition to personal liability for debt that you have guaranteed, you are still liable for your own negligence. For example, if you have a service and repair business and cause an accident that injures another person while driving to a job site, you are personally liable for your negligence. Certainly, the company can indemnify you, but that is an agreement between you and the company and is not binding on the person you injured. One solution is to have good insurance for your business. Usually, attorneys will pursue the insurance policy proceeds, then company assets before turning to your personal assets; but you need to be aware that if liability exceeds both your insurance and company assets, your personal assets are at risk.

In some cases, when there are no guarantees, pledged assets or personal negligence, you can still be held responsible for company liabilities.  The legal theories have names like, Piercing the Corporate Veil, alter ego, instrumentality, and equity formulation. These complex concepts cannot be fully explained in a few sentences but the bottom line is whether, in setting up and running the company, you followed the proper legal procedures to establish and keep the company a legal entity that is separate and distinct from you as an individual.  Yes, it is your business and ultimately your money, but if you commingle personal and business funds you are running the risk that you will be found personally responsible for business debts. Keep in mind that what satisfies the IRS may not be sufficient in a court of law.

While this is not an exhaustive list, there are a few common mistakes that many small business owners make that places their personal assets at risk.  When setting up a company, in addition to learning proper record keeping procedures for tax purposes, be sure to find out what record keeping and policies or procedures you need to follow to protect the business structure from a legal standpoint – then follow them!  Put an adequate amount of money into the business to get the company started (adequate capitalization) and leave enough money in the business to keep it running.  Always keep business and personal accounts separate.  Do not pay personal expenses with business money or business credit cards.  Do not try to decrease profit by padding payroll. Don't add a spouse, a child or other relative onto the payroll if they are not actually working for the company.  Don't pay them for 40 hours of work if they only work 1 hour a week.  Make sure the amount you pay them and yourself is reasonable. Good insurance is also important.

Finally, remember this is your dream and while there are no guarantees, part of owning a business is accepting a certain amount of risk.