Liability Protection and LLCs / Corporations

On my list of Reasons to Incorporate or Form an LLC, #2 is limiting personal liability. If you are a Sole Proprietorship, there is basically no legal distinction between you and your business. If your business owes Bob’s Hardware money, you owe Bob’s Hardware money. That means that your house, your car, your iPod, your whatever – is at risk if your business has debts.

Corporations and Limited Liability Companies (LLCs) are separate legal entities. That means there is a difference between you owing money to Bob and your business owing money to Bob. If your LLC fails and files for bankrupty, your house and iPod is safe. As usual, there are exceptions:

Personal guarantees. It’s very hard for a new small business to get a loan without what’s called a personal guarantee. That means you must put your own personal assets on the line to get the loan. Same thing with business credit cards. In the application fine print you’ll see a line saying that you personally guarantee the debts. Otherwise anyone could form a corporation for $500, get a credit card, buy $50,000 of stuff, and promptly file for bankruptcy.

Federal and state taxes. If you stiff Uncle Sam, he’ll get his money. No surprise here.

Unlawful activities. Many people think forming an LLC or corporation shields them completely from being sued. For example, my wife and I want to make dog toys, but we are afraid some kid might choke on our toy and we’d get sued. Forming a corporation does not mean we can be reckless and only worry about losing our tiny business. If the people suing you can prove that you knowingly created a hazard or defrauded people, they can ‘pierce the corporate veil’ and go after your personal assets.

Not treating the separate entities as such. If you are going to benefit from your LLC or corporation being separate, you must treat it that way. This does not mean only doing all the required paperwork. If your business is buying your baby’s diapers or other personal items, or you start cashing business checks in your personal account, the courts can disregard your limited liability status.

So, there you go. Forming a separate legal entities offers some nice benefits, but does not mean you can go around making self-lighting firecrackers for babies. Next, I’ll do some examples of potential tax benefits of forming a corporation or LLC. Remember, this is just my limited interpretation of library books and online research.