A key advantage of forming an entity for your business is to limit your personal liability. But if you don’t pay attention to the following suggestions, you might find yourself on the hook.
Sole Proprietorship vs. Legal Entity
Most business owners realize early on that if they operate as a sole proprietorship (i.e. – a business with a sole owner, which is not recognized as separate from its owner), they can be personally liable for all the debts of the business. This means that their car, house, and other assets can all be reached by creditors of the business.
To avoid this result, business owners are well advised to “incorporate” or “organize” a legal entity with the State for the operation of their business (the most popular legal entities being limited liability companies and corporations). Because the business operates as a legal entity distinct from its owners, the entity is typically liable for its own obligations and the owners are not personally liable. But there is more to this story…..
Although forming a legal entity provides significant protection, the reality is that owners can still be personally liable in certain circumstances despite having formed an entity for its operation.
A person is liable for his own actions and wrongdoings. So if a person’s actions result in fraud, malpractice, personal injury, etc., that person is personally liable to the injured party. The fact that the person was acting on behalf of the entity during the occurrence of the wrongdoing is irrelevant. Nevertheless, having the protection of a legal entity will prevent an owner from being personally liable for the actions and wrongdoings of other owners and employees of the business.
Because entities have few assets of their own, many creditors (vendors, lenders, landlords, etc.) will insist on obtaining a personal guaranty from the owner. If an owner personally guarantees the debts of a legal entity, he or she is personally liable on the contract.
In addition, if a contract does not clearly indicate that a person is signing on behalf of the entity (for example, “Joe Smith, President of ABC, Inc.”), he or she may be considered to have signed as an individual and be personally liable on the contract obligations.
Piercing the Veil
Where it is necessary to carry out justice, courts will disregard a legal entity even though it is legally formed. This is known as “piercing the veil”. The courts most often pierce the veil if an owner disregards the separate and distinct nature of the legal entity- i.e., treats it as an extension of his or herself. Some factors that weigh in favor of piercing the veil are if an owner treats the entity’s assets as his or her own, commingles personal and business funds, undercapitalizes the business, and/or fails to follow any required corporate formalities (such as holding meetings and issuing stock).
Knowing the exceptions that can subject you to personal liability is half the battle. A thorough review of your business practices can help to limit your exposure in the future.
Fuel Your Aspirations!
MOSO Nation Contributing Writer,
John Monahon is an attorney with Trusted Counsel (Ashley), LLC, a boutique corporate and technology law firm. You can find him on the web at www.trusted-counsel.com.