Understanding Limited Liability (and Where It Applies)

When starting your business, the choice of whether or not to create a legal business entity can be bewildering. Do you operate as a sole proprietor? Maybe take on a partner? Or do you go the next step and run your business as a legal entity that is distinct from your personal assets?

If you’re wary about operating your business as a sole proprietor, registering your company as a separate legal entity gives it limited liability in the event of a lawsuit against your business.

Limited liability is a benefit enjoyed by limited liability companies (LLCs), S corporationsC corporations and a few others. Because a company with limited liability is legally distinct from its owners, the business’ assets are also legally distinct from the owners’ assets. As such, in the case of most lawsuits, the owners’ personal assets are generally protected from the debts and liabilities of the company.

There are a few exceptions to this rule, but before we discuss those, let’s define “limited liability” for our purposes and see how it can help your business.

Defining Limited Liability

Generally speaking, the only U.S. business entities without limited liability are sole proprietorships and general partnerships. There are also hybrid entities as well, such as limited partnerships, which have “silent” partners with limited liability and at least one “managing” partner with full liability.

As a sole proprietor, you run your business under your own personal name. As a member of a general partnership, your name appears alongside other partners. Because of this, you assume personal liability for anything that happens within your business, meaning any asset that belongs to you can be seized to satisfy a judgment against the company.

For example, if a patron gets injured at a restaurant you own as a sole proprietor, you can be held personally liable for that injury, and your assets can be used to satisfy any judgment against the company.

Because of this risk, some business owners choose to protect their personal assets by structuring their business as a legal entity that provides limited liability. In the example above, if the business is run as a distinct legal entity with limited liability, the injured patron can collect damages only from the legal entity, not from the personal assets belonging to the owners.

With that example in mind, let’s look at a few of your options for business entities with limited liabilities.

Corporations

Corporations offer owners (often referred to as “shareholders”) limited liability as well as the ability to sell shares of the business. Corporations come in a few variants, but the most prominent are S corporations and C corporations.

Owners of S or C corporations are not held personally responsible for the corporation’s debts or obligations, thus limiting their owners’ liability. Shareholders are also protected from any judgments against the corporation as well, meaning its investors are also privy to limited liability.

For example, if a customer were to sue your business, your personal assets (such as your savings, home or other valuable items) won’t be at risk. Only the business assets will fall within the scope of the lawsuit.

The major difference between C and S corporations is their tax structures. Shareholders of a C corporation are subject to “double taxation”: they are taxed once at the corporate level and again at the personal level. On the other hand, the shareholders of an S corporation are subject to taxes only on the personal level. The profits or losses from the S corporations are “passed through” to its shareholders. 

Both types of corporations usually require a board of directors and/or executive officers to manage the business because of its size, diversity and complexity of operations. If you incorporate, you will need to file articles of incorporation, create corporate bylaws that establish formalities for running the business, and follow specific protocol to retain your corporate status. For example, corporations are required to maintain formal minutes of all meetings and document decisions and resolutions made.

As a business owner, the limited liability benefit of a corporate structure may be outweighed by the taxes, energy and administrative commitment required to form one. Fortunately, there is an alternative to forming a corporation and still maintaining limited liability.

Limited Liability Company (LLC)

An LLC is another legal structure that offers the benefit of limited liability while avoiding the double taxation of corporations. Members of an LLC receive protection from personal liability of business debts. Additionally, LLCs protect its members from damages stemming from acts committed by other co-owners or employees.

For example, if a court finds an employee or co-owner liable for any wrongdoings or negligence, the LLC’s assets will be used to satisfy the judgment, or the co-owner or employee could be held liable, but other members of the LLC will not.

An LLC is a pass-through tax entity, which means that business owners don’t pay taxes on net profits. Instead, they report their profits and losses on their personal tax returns, and they are taxed individually based on the income.

LLCs offer a more streamlined management structure than corporations, and owners typically run the day-to-day operations. The LLC entity is often preferred by small business owners who want to be involved in actively managing their businesses. If you run your business as an LLC, you have two options of how to structure your business:

  • Member-Managed: The owners of the business run the business. Use this designation if all owners want to be actively involved in everything from developing products, to producing and selling them. Be aware that, under most state laws, LLCs are member-managed by default.
  • Manager-Managed: Designated owners, non-owners or a combination of both run the business, and only designated people have a vote in business decisions. For example, if you have investors who don’t want to be involved in day-to-day business operations, you would choose this option.

To gain LLC status, you will have to file articles of organization with your local Secretary of State Office and create a written LLC operating agreement, which establishes members’ rights, responsibilities and share of the profits.

Which Option Is Best?

There are situations in which corporations are favorable to an LLC. If you or other owners hope to build up the company for an eventual acquisition or initial public offering (IPO), forming a corporation would be favorable, as both S and C corporations can sell shares.

Another pitfall of LLCs is that its members are also considered self-employed, which means that any and all profits are subject to the self-employment tax. Should you wish to avoid paying the self-employment tax on all of the business’ profits, you may want to consider forming a corporation.

In some states, you may also have the option to create a limited liability partnership (LLP) depending on your type of business (in California, for example, only accountants, lawyers and architects can form an LLP). An LLP provides limited liability to its members, but not to the same degree as a corporation or LLC. In an LLP, partners are held individually liable for their own actions and not those of other partners. This is similar to the principle behind a limited partnership (LP).

Exceptions to Limited Liability

With both corporations and LLCs, there are exceptions in which you can be personally responsibility for debts or obligations. These include: 

  • You personally and directly injure a person.
  • You co-signed on a bank loan or a business debt, and the business defaulted. Many creditors will require you to personally guarantee any business loans, credit cards or other extensions of credit to your LLC to minimize their risk. If your LLC’s assets won’t cover the debt that you authorized in your name, then you will be personally liable to make up the difference.
  • You didn’t deposit income taxes withheld from employees.
  • You commit fraud, break the law or do something reckless, and your actions hurt the business, employees, customers, partners, investors, vendors and/or other persons or entities connected with the business.
  • You don’t treat the business as a separate legal entity and instead make it an extension of your personal affairs.

Whether you opt to form an LLC or a corporation, understand that limited liability only extends to plausible, legally defensible situations that may occur in the course of your business. Limited liability does not exist to give unscrupulous business owners cover from unlawful conduct. It’s simply a way to protect ethical business owners in the event of an incident that may otherwise deplete their assets. 

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