BY JACINDA MITCHELL
Whether you are setting up a business or are already in business, it is vital that you have protection over your personal assets (home, car, investments, and so on) from any creditors that may arise from litigation or debt. A Limited Liability Company (LLC) is a useful tool to protect your personal assets.
When an LLC is formed, a new business entity is established that is legally separate from its owners. Whereas in a sole proprietorship or partnership, there is no distinction between business assets and debts and personal assets and debts. If a sole proprietor cannot pay business debts, then creditors are able go after personal assets. This is true for the reverse if there are personal debts to be paid.
For example, let’s say that Joe Anderson starts his own accounting business. If Joe sets up the business without creating a legal entity (such as an LLC), in the eyes of the law, his business is now a sole proprietorship. This is an issue from an asset protection perspective because Joe’s personal assets are now available to pay business debts. If a client decides that Joe has performed negligently in his role and want to bring litigation by suing him, Joes personal assets are at risk of being used to settle the business debts and liabilities. If Joe had started the business with his wife Jane, but still failed to create a legal entity for it, the situation would be the same as the business would be viewed as a partnership. Now let’s say that Joe created a separate LLC when he set up his business and the disgruntled client is threatening to sue. Joe will be able to sleep easy at night knowing that the roof over his head is safe, as the LLC is legally separate to Joe. The creditors are only able to go after assets that Joe has invested into the business. Utilising an LLC effectively puts a wall between Joe’s assets and the business’ assets.
An example to further clarify is the following- John Smith operates his business as a sole proprietorship. His business then gets caught up in an economic downturn resulting in financial difficulties such as loss of market share and defaulting loans. Say John’s business is then $1.5 million in debt. John’s personal wealth is $1.2 million and he invested 150k in to the business. Because John ran his business as a sole proprietor, every asset he has personally is at risk. John stands to lose his personal wealth of $1.2 million plus the $150k he invested into the business. If John had operated his business as an LLC, a wall separates his personal assets from his business assets. John would still stand to lose the $150k that he invested into his business, but his personal wealth of $1.2 million would be inaccessible to creditors.
It is important to note that there are some exceptions to the protection of an LLC. An LLC owner can be held personally liable if they personally and directly injure someone, if they personally guarantee a bank loan or business debt on which the LLC defaults, if they fail to deposit taxes withheld from employee wages, if they intentionally do something fraudulent, illegal, or reckless that cause harm to the company or to someone else, or if they treat the LLC as an extension of their personal affairs rather than a separate entity. The last point is one of most importance as if the court decides that the LLC is just an extension of personal affairs and not a separate entity, it may be deemed that the LLC doesn’t exist and the owners were doing business as individuals and thus liable.
To avoid the LLC being deemed as non-existent, an LLC owner should leave no room for doubt. Precautions should be taken such as not concealing or misrepresenting material facts to vendors or creditors, funding the LLC to ensure there is enough cash in the business to meet foreseeable liabilities or expenses, keeping personal finances out the LLC accounting books, and having an operating agreement for the LLC.
The LLC is great vehicle to protect your personal assets if it used correctly. Having an LLC for your business is much like having an insurance plan in place for any future liabilities or debts- a worthwhile investment, for sure.