It’s something that none of us wants to think about.
What if something goes terribly wrong with your small business? Imagine:
- You’re a dog walker. Your client’s dog darts away, yanking the leash out of your hand, and then is injured running into traffic.
- You’re a freelance proofreader. A brochure you signed off on is found to have a typo that requires reprinting.
- You’re a photographer. At a high school senior portrait session, you invite the student to step to the other side of a tree. But the ground is loose and the student falls, hurting her leg.
Yikes. Now, the point isn’t to scare you – these are made-up scenarios, after all.
But, despite everyone’s best intentions, accidents do happen on rare occasions. And even though we wish it weren’t the case, some unscrupulous people may be quick to take advantage of a situation, or even invent a reason to sue.
Sometimes, issues like this aren’t resolved amicably. Some even end up in court.
That’s when it pays to have limited liability protection for your business.
A limited take on limited liability
First, a disclaimer: In the scenarios above, you might consider several ways to hedge your risk as a small business owner, including buying industry-specific insurance or having your client sign a waiver form up front.
In this blog, I’m not taking a position on such strategies.
Instead, this piece solely concerns how you can structure your business to limit your personal liability.
Consider this scenario: You and your spouse have been married for some time. You own a house together, you have a nest egg set aside for retirement, and you have savings earmarked for your child’s college education.
You start a second career as a personal trainer. But then one of your clients gets hurt during a workout session, and the unthinkable happens: Your client is seeking damages from you.
Whatever the merits of the case, you want to constrain that lawsuit to your business assets – after all, this was a work-related incident. You certainly don’t want a disgruntled client to be able to lay claim to the personal assets that you share with your spouse.
What is your company, anyway?
There are ways you can set up your company to provide limited liability protection – that is, to limit your personal liability in a business dispute.
But those steps need to be taken beforehand. It won’t work to try to restructure your company (and insulate your personal assets) after an incident occurs.
To begin, it’s worth asking yourself: What is my company?
If you work for yourself and you don’t have any employees, it’s likely that the IRS considers your business to be a “sole proprietorship.” Or, if you and a friend run a birthday entertainment or personalized stationery business together, your business might be a “partnership.”
If your goal is to create limited liability protection, you’ll want to consider new classifications for your business, beyond being a sole proprietorship or a partnership. I’ll discuss two popular options, an LLC and an S Corporation, below.
To be clear, each option comes with its own advantages and obligations. You should talk with your tax and financial advisors about the implications of business structures such as an LLC or S Corp. Here, all I’m focusing on is the major upside to both, which is limited liability protection.
Limited Liability Corporation (LLC)
An LLC is a type of business – in fact, it’s the fastest-growing business type nationwide. The popularity of LLCs stems from their flexibility and wide applicability – many small businesses opt to become LLCs to gain limited liability protection.
A few highlights to know:
- Easy to set up LLCs aren’t particularly complicated. There are only a handful of steps involved in creating an LLC.
- Pass-through taxation If you own an LLC, the IRS will consider you to be self-employed, which means that your taxes will “pass through” to your personal income tax return, where you will pay self-employment tax. Or, LLCs can choose to be taxed like S Corporations, described below. Talk to your tax advisor about your particular circumstances.
- You need a registered agent and an operating agreement A registered agent is someone with a physical mailing address who is designated to receive any legal documents on behalf of the LLC. The LLC’s operating agreement details the rights and responsibilities of the LLC’s owner(s).
- Range of costs by state There is an annual fee to maintain your LLC. It can be as little as $100 in some states. It’s closer to $500 per year in others – still worthwhile if you are shielding significant personal assets.
To create an LLC, start with your state government’s website. Or turn to online resources – many will help you navigate your state’s filing requirements, for a fee. Just type “start an LLC” into your search engine.
S Corporation (also called an S Corp)
An S Corp is not a business type, but a tax classification – “S” refers to a certain applicable section in the tax code. It’s another option that can provide limited liability protection for your small business.
Highlights to know:
- You’re an owner-employee Unlike in an LLC, where the IRS sees you as self-employed, you work for the S Corporation that you create.
- You’re paid a salary You “pay yourself” a reasonable salary for the work that you do. You will pay income and self-employment tax (Social Security and Medicare) on that salary. You can also receive reasonable dividends from the company.
- You need a registered agent and a shareholder agreement A registered agent is someone with a physical mailing address who is designated to receive any legal documents on behalf of your S Corp. A shareholder agreement establishes important rules governing the S Corp.
- More paperwork Classifying your business as an S Corp may mean filing additional tax forms and setting up a payroll system. Just like with an LLC, there are annual fees associated with maintaining your S Corp.
To create an S Corp, start with your state government’s website. Or, here again, you can find no shortage of online resources offering to help set up your S Corp, for a fee. Just type “start an S Corp” into your search engine.
Maintaining the veil
With either an LLC or an S Corp, you’re creating a “veil” between your company and your personal assets. “Veil” is actually a legal term in this case, referring to the separation between your company and what you own personally.
Once you’ve taken steps to insulate your personal assets from a business lawsuit, you want to avoid doing things that will allow a lawyer to “pierce the veil” – another legal term – and argue that your personal assets should be fair game, after all.
The first of these is easy: Just run your business honestly. Not an issue, right? But, for the record, doing something illegal is one way that a business lawsuit can encroach on your personal assets. (Negligence can have the same result.)
Also, don’t “comingle,” or mix, your business and personal money. If you do that, a lawyer can argue that your business isn’t really the separate entity it appears to be on paper.
For this reason, it’s important to have a business checking account. Yes, you can “pay” yourself by transferring money from your business account to your personal account, on a recurring schedule. But you don’t want business money being used for personal purposes, and vice versa. That opens you up to charges that you’re using your business as a piggy bank, and that it’s not a distinct entity.
Finally, remember to keep your annual state filings current and paid up. If your LLC or S Corp state registration has lapsed, that too can “pierce the veil” of limited liability protection, putting your personal assets at risk.
This content is for informational purposes only. Consult with your tax or legal advisor before making any decisions regarding business structures, tax matters, or liability.