Updated: Apr 23, 2019
There are 2 reasons to start a business: (1) saving money on taxes from income producing activity, and (2) protecting your personal assets from creditor liability. This post concerns protecting your personal assets from creditor liability.
You protect your personal assets by doing business under a separate legal entity. Certain business formations are separate legal entities from their owners and creditors can only pursue the assets of the legal entity that is liable on the debt. Separate legal entities include partnerships, corporations, and LLCs. A sole proprietorship is not a legal entity and does not offer liability protection. An LLC is the easiest to form and offers owners the choice of what type of legal entity they would like the LLC to be taxed as.
Doing business under a separate legal entity would be the only necessary step for asset protection if it wasn't for piercing the corporate veil. The corporate veil is liability shield for the owners created by the separate entity. Piercing the veil refers to creditors being able to pursue the personal assets of the business owners for the business' debts. This may seem illogical considering that the business entity is formed for the liability protection, but it actually makes sense considering how the veil is pierced.
The underlying theme behind piercing the veil is that the owner(s) of the business use the business as if it is not a separate entity. The theory used to pierce the veil is that the business is the alter ego of the owners. Basically, a court will look at about 5 factors to determine whether the business is really an alter ego, and if they find that it is then the owners are personally liable to the creditors. These factors are (1) the failure to observe corporate formalities, (2) shareholders holding themselves out as personally liable for certain corporate obligations, (3) diversion of funds or other property of the company for personal use, (4) absence of corporate records, and (5) the fact that the corporation was a mere facade for the operations of the dominant shareholders.
All of this means that protecting your personal assets while doing business is a 2 step process: (1) create a separate legal entity, and (2) use the 5 factors to show that your business is not your alter ego. The good news is that the factors are not complicated and can be complied with efficiently. For starters, factors (1) and (4) rely on company records. Company records include the bylaws, which are the rules governing the company. Failing to draft bylaws creates an absence of company records (factor 4) and a company cannot follow company formalities if it never creates company formalities by drafting bylaws. Therefore, drafting and following the bylaws can protect against 2 of the 5 factors, which is 40% of the goal.
The discussion of bylaws deserves a special note to single member LLC's. A single member LLC offers no tax advantage because it will be treated as a "disregarded entity" for tax purposes and will receive the tax status of a sole proprietorship. This means that the only reason a person would create a single member LLC is for the liability protection. A person would not normally draft a document of rules for only themselves to abide by. However, if bylaws affect 40% of the factors used to pierce the veil, then a single member LLC needs to draft bylaws or they could have their personal assets at risk. Without the liability protection, a single member LLC is completely worthless so even these companies need bylaws.
As far as the other factors are concerned, the discussion is simple. To prevent holding yourself out as personally liable for company obligations don't sign deals with your personal name, don’t guarantee that any payments or contracts will be completed using your personal name, and don’t tell people any of these things even if they aren't in writing. To prevent diversion of funds, don't use the company card to pay for your personal expenses, and don’t use your personal account to pay for company expenses. Transfer money from one account to the other before using it in the proper account, and write a receipt for the transaction. All transfers from your account to the business are loans, and all transfers from the business account to yours are either distributions of income related to your ownership or they are repayments of the loans you have been recording. The final factor mainly concerns using the business for fraud, so don't run away with people's money and you should be good.
Between the tax consequences of the business structure, the liability consequences of company actions, and the drafting of bylaws, there is a lot to consider when starting or operating a new business. If you have any questions along the way, or just want the process to go a bit smoother, please contact me. I'm here to help.