Understanding Limited Liability Protection
Putting the Limited Liability in Limited Liability Company
One of the biggest benefits of establishing a formal business entity, rather than operating as a sole proprietorship, is the limited liability protection that an LLC or corporation can offer its owners. But you may not realize what that really means or why it is so important, from a liability perspective, to form a corporation or limited liability company.
Starting a sole proprietorship is easy. You just go out and start conducting business. So, if you sell a product or provide a service without some formal entity status, you are conducting business as a sole proprietorship. Because it is so easy, the sole proprietorship model is very common. But just because something is easy doesn’t mean that is the right thing to do.
The basic rule is that, in terms of personal liability, the law does not distinguish between you, the sole proprietor, and the business. This means that if there is a business debt or the business were to incur some kind of legal liability, then you have that debt or legal liability. There is no shield in between the debts and wrongs of the business and your personal assets. So, your individual property, from houses, cars, to bank accounts and more, may be on the hook to pay for the debts and liabilities of the business.
For corporations and LLCs, owners of the business are usually not personally liable for the debts or liabilities of the business. The owners ordinarily enjoy limited liability protection, where they are only liable to the extent of the money contributed to the business, while their personal assets remain protected. Limited liability protection was one of the primary reasons the law first started recognizing corporations and LLCs as separate entities apart from their owners.
However, this is not an unbreakable rule. LLC and Inc. owners may still be liable for their personal conduct. For example, banks may request or require business owners to personally guarantee business loans. The extent of personal liability under that guaranty would be a point of negotiation, but, if signed, the guarantor is personally liable to some extent or another for the guaranteed debt of the business. Also, if a court determines that the “corporate veil” should be lifted and the limited liability status ignored, then personal liability may be assessed.
So, while personal protection under the LLC or corporate model is not unlimited, it is substantially more protective than the sole proprietorship. As always, I recommend you consult an attorney when trying to decide the proper way to implement and maintain the limited liability model of a corporation or limited liability company. But, in the meantime, keep in mind this key distinction between sole proprietorships and corporations/LLCs as you consider your next entrepreneurial move.