A business entity can provide personal liability protection for its owners. The problem is that many people start business without proper instruction on how to run and manage agreements between parties, agreements with customers, internal paperwork, cash controls, voting rules, state and Federal reporting requirements and a host of other issues.
In fact, we have found between 20 to 25 actions, behaviors, or neglected tasks which commonly cause a business structure to be forfeited and can result in personal liability for the owner or owners.
Here are 5 of them:
1. Using the Business for Fraudulent Activities
You cannot, should not, and shall not use your business to cheat or defraud!
For example, John Smith gathers money from investors claiming that he will develop a new product for his company. He never had planned to use this money for product development. He is sued by the investors, but John claims that his personal assets are protected since he was acting as the president of his limited liability company. No court will honor the limited liability company since fraud was involved. His personal assets and business assets will be at risk.
You may think that since this is an egregious example, it won’t ever happen to you. However consider the fact that many deals struck with the so-called motivated sellers could give rise to a lawsuit under your state’s Deceptive Trade Practices Act (DTPA) or similar statute. Sometimes the line is not so clear. One bit of wisdom is to make sure that your agreements are fair:
- You also can’t be wholly unfair or flagrantly one-sided when dealing with customers. A court can always look at a one sided transaction and either decide against you. Even worse a judge could declare that you are using the business to promote unfair dealings. This is bad news for you!
- Ask yourself: Would you want to be the buyer/customer on the other end of your deal? Despite popular conception you can structure win-win deals with motivated sellers and make money. Ever hear of karma? Everything you do to or for another person will one day be done to or for you so be fair!
2. Failure to Respect the Business as Separate from Its Owners
You shall not mix funds from business accounts with your personal funds, accounts, etc. Do not use company money to buy personal assets, groceries, and other things.
Simply put, if you do any of these things routinely (or perhaps only once) then your business structure is not likely to hold up in court. If you think this is another easy one then WATCH OUT, because there are other more complex issues relating to the use of business and personal assets in the business. For more information see some of our top-rated courses.
3. Insufficient Capitalization
Insufficient capitalization means failure to properly capitalize the business. In other words, a lack of reserves and/or insurance coverage.
If your business does not have enough capital and/or insurance to cover operating expenses and potential liabilities then a state court will likely pierce the business entity and hold the owners personally liable. Why would a court do this? The reason is to find the money . Your business must have enough insurance and/or savings to cover expenses, liabilities, and obligations. The amount of capitalization generally refers to the total value of assets (equipment, cash, etc.) in the company and the amount of insurance coverage. This is another COMPLEX area because you may need more or less capitalization based on your business type.
A general rule is: the more you deal with the public, the generally the greater your required level of capital.
4. Forgetting to File State Reports
Your secretary of state s office will require you to keep up with reports and state taxes (sometimes called franchise taxes and/or business privilege taxes). If you don t keep up with these reports and/or taxes (even if nominal amounts are owed) your business privileges will likely be revoked. Guess what privilege goes first?: The personal liability protection.
5. Other Formalities
These include meetings, paperwork, required records, proper roles and obligations among the parties, and transfers of ownership interests, and more. It is very rare that we see full step-by-step and easy-to-follow details on creating iron-clad records in these areas. For state liability protection and the ability to satisfy IRS auditors you need to understand these rules!
The list does not stop here, because we have found between 20 to 25 areas which are common traps for the business owner. While we have covered 5, many of the others are very easy to miss but just as important. Please make sure you get proper instruction on how to run your business entity after it is created! The true lost art is learning how to maintain the protection of your LLC or corporation.
Article originally published in July 2007
Recommended Books on LLC or Corporation:
- LLC or Corporation?: How to Choose the Right Form for Your Business
- The LLC or Corporation Start-Up Guide (Quick Start Your Business)
- Business Structures: Forming a Corporation, LLC, Partnership, or Sole Proprietorship (Entrepreneur Magazine’s Legal Guide)
- Your Limited Liability Company: An Operating Manual (Your Limited Liability Company (W/CD))
- Run Your Own Corporation: How to Legally Operate and Properly Maintain Your Company Into the Future
About the Author:
- Setting Up a Limited Liability Company and S Corporation in California
- Election of LLC as an S Corporation or C Corporation?
- Incorporation and Filing DBA Papers
- How to Bullet Proof Your Corporation
- Incorporate Your Business: Why and Where