Many new business owners don't understand legal the risks involved in starting their own businesses. In the case of a successful lawsuit against your small business, your liability as owner can extend to virtually every tangible asset; a position of unlimited liability is not a comfortable position to be in. Entity formation and insurance policies can be employed to avoid potentially ruinous damages.
The most effective way to protect your personal assets is to form an entity or trust that exists outside your person. For a business, an entity usually takes the form of a corporation, an LLC, or an official partnership. Each state has an office that handles entity formation. Different businesses will find different entities more advantageous.
Remember one key difference between corporations and LLCs: in a corporation, a creditor can become the owner being paid with shares, whereas in an LLC, a creditor cannot seize or force the sale of a member's controlling interest. This means that falling into debt will not only protect personal assets but also will protect ownership of the company. LLCs also provide other special benefits, such as the protection of salaries (including the owner's). For families, a FLP (Family Limited Partnership) can protect against liability that could occur through personal claims, particularly involving injury or accident.
Entities are not impenetrable, as there are several legal exceptions that strip away the liability protection that entities provide under certain circumstances. Transferring funds to or from business accounts after your business has a creditor could be considered fraudulent and grounds for piercing the corporate veil.
Other types of fraud that can remove entity protection (thus leaving personal assets vulnerable) arise from using business assets for personal use and misrepresenting company products or services. Keeping thorough records, conducting honest business, and keeping personal and business accounts separate will secure personal assets in the event of debt from failed businesses or lawsuits.
Be Careful with Contracts
Remember: a personal guarantee to cover debt will put your personal assets at risk, no matter your business entity. Sometimes making a personal guarantee is nonnegotiable, as is often the case with bank loans. In these cases it may be wise to attach a sunset provision, or offer some other kind of collateral.
Deals with suppliers should not include a personal guarantee, as this negates the primary benefits of entity formation and protection. Whenever possible, contracts should be designed to limit damages and liability, not exacerbate them. It is a good idea to sign contracts as your company rather than as your person, as this will avoid future confusion about whether or not your signature constitutes a personal guarantee.
Appropriate insurance policies can mitigate damages in the event that a creditor pursues your personal assets. Liability insurance can help settle personal injury lawsuits, and property insurance can cover tangible assets so that you won’t have to go into debt to replace them.