Limits on Limited Liability: When You Become Liable For Your Business’s Debts
Many people form LLCs or corporations to protect their personal assets. You don’t want to lose your car, your house, or your personal savings because a business venture didn’t work out.
Forming an LLC or corporation gives you access to limited liability. But LLCs and corporations must be property run to maintain that limited liability.
There are several ways you can lose limited liability status—and put your personal savings and property on the chopping block to pay back company debt.
You’ve decided to start an LLC to protect your personal assets from a real estate business. Perhaps you’re buying a home to flip or rent out.
Or you’ve started a business that requires you to rent significant equipment—for example, your trucking business is leasing a tractor-trailer, or your construction company is renting some heavy machinery.
If you’re getting a mortgage, a loan, or renting expensive equipment, the banks and rental services are going to be weary of providing money to a fledgling LLC. As a result, they’ll likely demand you sign a personal guarantee.
As a result, you will be personally liable for the loan, the debt, and/or the equipment. If your company can’t pay, you’ll be personally responsible because of the personal guarantee, regardless of the company’s limited liability.
Keep in mind: More than one person can sign on a personal guarantee. If you and your two co-members of the LLC sign a personal guarantee, you will most likely be jointly and severally liable. That means, if you have more personal assets or are otherwise the easier person to collect the debt from, the bank or other entity can demand you pay the entire amount of the loan.
You may still have a legal right to demand your co-members pay you their fair share—but if they refuse, you may need to litigate. If they don’t have the money to pay you, you may end up footing the entire bill.
CONCLUSION: In rental and loan situations, you may not be able to secure the money or assets without providing a personal guarantee. Know what you’re signing and its consequences. If, for example, you’re signing a personal guarantee for rental equipment but your LLC co-member will be the person with direct control or access to the equipment, understand that you are taking a substantial personal risk if the company fails—and your co-member doesn’t readily return the equipment.
Ignoring the Paperwork
You’re not going to hear many people say, “I wanted to start my own business because I love paperwork!” But paperwork and “legal formalities” are a necessary and vital component for maintaining your limited liability.
Even if you do not sign a personal guarantee, you can be liable for the debt of your company. There is a legal doctrine called “piercing the veil”—where “the veil” refers to limited liability. If you do not correctly operate your LLC or corporation, a creditor can still claim your personal assets (and those of your co-owners).
A court will look at whether your limited liability entity is being used to defraud creditors or otherwise avoid paying lawful debt. It will look to whether it is fair (equitable) to hold you personally accountable for your company’s debt.
What convinces a court to pierce the veil? Generally, the court looks to whether your company was run as a fully-separate entity from you (and your co-owners), or whether the LLC or corporation was just an alter ego for you, a shield for you to run your personal affairs while still trying to hide behind limited liability.
The first place the court (and your creditors) will look is your LLC or corporate records. Did you properly form your LLC or corporation? Do you have an operating agreement or bylaws in place? Did you document in writing all your LLC or corporate interactions?
Your LLC or corporation exists on paper. That means, anything that it does or engages in should be properly memorialized in writing.
CONCLUSION: People are held personally liable where they don’t bother to maintain the paperwork. They do deals with a handshake; move money around without documenting for what and where; and, fail to file necessary forms with state and federal authorities.
The result is creditors coming after their personal assets, and a court determining that the failure to maintain the limited liability entity properly means it doesn’t exist at all—and thus affords the owners no liability protection.
Commingling Assets (“What’s Mine is Yours”)
Your LLC or corporation is a separate legal and financial entity. You can transfer or loan money or assets to your company. The company can issue you profits or other assets for your role as an owner or your work as an employee. As above, all of that should be in writing.
But when money or assets are flipping back and forth between you and the company, you’re commingling assets. That can happen in many ways: you’re paying company bills from your personal account; you’re paying for that family vacation or family meals on your business credit card; or, that top-of-the-line television set started in the company’s waiting room and ended up in your living room.
Another scenario where this arises is with founders who start multiple companies but don’t respect the corporate boundaries of the different companies. They’ll use the assets of one company to pay the expenses of another company, or the resources of one company to handle the business of a different company. If you don’t respect the boundaries of your different companies, including having separate bank accounts and completely separating resources for your different companies (or written agreements in place, under reasonable terms, to permit one company to provide services to the other), your creditors and the courts won’t respect those corporate boundaries, either.
FIX YOUR THINKING: What you own, you own. What the company owns, the company owns. Imagine your company as a neighbor you barely know. Since you can’t walk into your neighbor’s house and “borrow” their TV, you cannot do that with your company. This goes for money, assets, and company services.
You can loan money to the company, and you can receive benefit from the company. However, it must always be through a formal relationship with the company. Owners can receive disbursements. Employees can earn salaries. Customers can buy goods and services. When you receive money, assets, or services from the company, identify what role legally permits you to do that. THEN make sure to properly formalize that exchange in writing.
Setting Up a Company That is Doomed to Fail
Nothing says “this was all a scam against my creditors” like underfunding an LLC or corporation. If a business never had the capital needed to have a chance at success, a court will view your LLC or corporation as a “shell” enterprise that you knew was doomed from the start. Also, if you are in an industry where there are significant risks, such as a car-sharing business, construction, or medical services, you need to be insured for those risks.
Again, maintain a written record of all transactions. Properly document business relationships and money transfers. And keep a record of board, member, and/or shareholder/stockholder meetings. The more a court can see the story of your company—even if it ultimately doesn’t succeed—the more likely you can protect your personal assets behind limited liability.
Failing to Represent Yourself as an LLC or Corporation
Remember, your LLC or corporation is a separate legal entity. If you hire Steve as an employee (with Steve’s credentials) but Bill shows up for work, you’re going to have a problem with that. Similarly, if you make agreements with suppliers, employees, or other entities under your own name—whether oral or written agreements—then later claim limited liability behind your LLC or corporation, a court will look at your behavior as misleading your suppliers, employees, and other entities. If people reasonably believe you’ll be personally liable if something goes wrong, then you will be.
CONCLUSION: Clearly and expressly operate and do business under the company’s name. That “LLC” or “Inc.”—the legal indication that it’s a limited liability company—should be written after your company name in every legal document—including contracts, invoices, and even letterhead. If people don’t know they’re dealing with a limited liability company, rather than you personally, you’ll more than likely end up personally liable for those dealings.
Reverse Piercing the Veil
If you don’t know someone well and trust them fully, do not go into business with them. We’ve already discussed how you can be personally liable for the debts of your company. But the reverse is also true.
Where a co-owner (usually a controlling shareholder) engages in fraud or other wrongful conduct—using the business’s name, for example—to run up personal debt, the business can be liable for the personal debts of the co-owner. Put simple, one “bad” co-owner can put the company on the hook for his or her personal debts.
CONCLUSION: If you wouldn’t trust someone (or don’t know enough about that person to trust him or her) to watch your house or pet, take care of a loved one, or loan that person money, you should strongly consider not going into business with that person. Your business could fail because it becomes liable for the personal debts of one of its co-owners.
Conclusion: Forming an LLC or Corporation is Only the First Step
You don’t buy a plant and expect it to survive without watering it. You can’t form an LLC or corporation and expect it to survive (and continue to protect your personal assets) without maintaining it properly.
Think of your LLC or corporation as a separate person who will question every interaction you have with him or her. Result: You need to record the legally-enforceable terms for all your dealings with that “person” in writing.