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.

TO DOCUMENT OR NOT DOCUMENT, THAT IS THE QUESTION

Over the years, I have had a number of clients tell me that they do not document employment issues because they are afraid that their documentation will be used against them. For this reason, they keep as few records as possible. This discussion usually occurs when the client’s case has been damaged by their lack of recordkeeping. Of course, it is always possible that the documentation you keep will be used against you at a later time. However, it is also true that the lack of documentation can also hurt your case. For example, if you do not have documentation, created contemporaneous with the events recorded, you have only your testimony that events occurred as you state. The disgruntled former employee will disagree. Who will be believed? The employer who is often perceived as a soulless deep pocket or the poor victimized employee?

In what kinds of cases can documentation be important? Department of Labor wage and hour reviews and unemployment hearings are two examples. Documentation is particularly important in court cases associated with wrongful discharge, defamation, discrimination, retaliation and other similar employment related claims filed by a former employee.

Most lawyers, myself included, encourage clients to keep better documentation. While consistently documenting files can be time consuming for the small business owner with more urgent business issues on their mind, there are some quick, simple solutions. One thing you can do is to keep e-mails regarding a particular issue in a separate, password protected, electronic folder. You can periodically print the e-mails and file the hard copies. Just be sure to backup your computer system periodically and keep in mind that it is important to keep the information confidential and in a file that can be kept secure from the prying eyes of other nosy employees.

Only you can decide whether you will keep documentation but you should be aware that there are pros and cons to be weighed.

Employee or Independent Contractor?

A hot issue with many small businesses is whether people they hire to assist them are employees or independent or sub contractors. Small business owners are often on a tight budget and have little time to spend dealing with payroll and employment issues so they opt to hire people and improperly designate them as independent or sub contractors, giving them a 1099 at the end of the year. While this may save time and money initially, this can become a costly problem in the future.

What many small-business owners do not understand is simply designating someone as an independent contractor does not make them an independent contractor in the eyes of the law. So, when is an independent contractor or a subcontractor actually an employee? From a legal perspective, an employee is an individual for whom the details of their work are controlled by the person who hires them (employer). As a general rule, an independent contractor is someone who is hired to undertake a specific project but can choose the method of accomplishing their task. For many years Kentucky courts have looked at a variety of factors to determine whether an individual is an employee or an independent contractor. These factors include:

(a) the extent of control which, by the agreement, the master (boss/employer)may exercise over the details of the work;
(b) whether or not the one employed is engaged in a distinct occupation or business (Do they have their own company?);
(c) the kind of occupation, with reference to whether, in the locality, the work is usually done under the direction of the employer or by a specialist without supervision;
(d) the skill required in the particular occupation;
(e) whether the employer of the workman supplies the instrumentalities, tools, and the place of work for the person doing the work;
(f) the length of time for which the person is employed;
(g) the method of payment, whether by the time or by the job;
(h) whether or not the work is a part of the regular business of the employer; and
(i) whether or not the parties believe they are creating the relationship of master and servant.

See Brock v. Pilot Corp.,234 S.W.3d 234 (Ky.App. 2007); Sam Horne Motor & Implement Co. v. Gregg, 279 S.W.2d 755, 757 (Ky. 1985); and Ratliff v. Redmon, Ky., 396 S.W.2d 320 (1965).

The extent of control you have over the details of the work being performed; whether you provide the supplies and tools for the job and whether the individual is paid by the job or the hour, are perhaps the three most significant of the above factors. Generally, an independent or sub contractor has their own business, is given the project with a completion date and the contractor decides how to complete the project on time. They set their own hours, work either where they want or if the work is required to be performed at a certain location they schedule the time that they can come to the project site. Usually, they have other jobs, projects and other companies for whom they are doing work. On the other hand, an employee may also be working on a project; but their work hours are controlled by the employer, the tools and equipment are most often provided by the employer. Other rules are often imposed by the employer. For example, when a break may be taken, when the individual can take off work or how the work is performed. Take for example a builder who needs to have a building framed. In some circumstances, the framing can be done by an employee or an independent or sub contractor. Compare the following:

When Builder A needs to frame a building, he generally hires the same individuals, he tells them where the job site is and when to be there, the builder provides the wood and other supplies, the individuals use the builder’s tools and equipment and the builder directs the details of the framing. The framers are closely supervised and the builder specifies when they take their lunch break and how long and when they take other breaks during the day. The builder either pays them by the day, weekly, biweekly or monthly for the hours they work. Even though the builder sends them a 1099 and has them agree that they are independent or sub contractors, these individuals are really employees. They may be temporary or part-time but they are not, true independent contractors.

On the other hand, when Builder B needs to frame a building, he contracts with a framer who has his own employees, uses their own equipment and supplies. The contractor is given a completion date, the plans and specs for the building and usually purchases the wood and other supplies needed to complete the job. Payment is a set amount for the project and is paid as specified in the contract, usually in installments based on a percentage of work completed or at the end of the project. The contractor is not paid by the number of hours worked. This is a true independent or sub contractor situation.

No one factor is determinative and the courts and public agencies look at the total circumstances. For example, you may hire an accountant to do your tax returns, a lawyer to give you legal advice on an employment termination or an IT specialist to design your website. You pay each of these by the hour but they are hired for a specific project, have their own business and other clients. In this situation, they would not be employees.
The part-time framer may work for other companies as work is available but this does not make him or her an independent contractor.

Improperly designating a worker as an independent or sub contractor instead of as an employee can cost the business owner far more money than they would have spent if they had hired a payroll service and paid the worker as an employee. Tax penalties, unemployment and worker’s compensation liabilities are just a few of the costly problems that can arise.