You’ve just set up your business by forming a Corporation, Limited Liability Company (LLC), or Virginia Business Trust (VBT). You’ve filed all the necessary paperwork with the Virginia State Corporation Commission, and you’re ready to launch! (In this article we’ll refer to any of these types of business structures as a Limited Liability Entity although that specific term isn’t a “thing” under Virginia law. Although each structure—the Corporation, LLC, and VBT—has different advantages and disadvantages, they share similar weaknesses if not managed appropriately and that’s why we’ll refer to them collectively as Limited Liability Entities.) Having established your Limited Liability Entity, you’ve protected your personal assets from any claims that might arise out of your business activities, right?
Hold on—it’s not that straightforward. While establishing a Limited Liability Entity is necessary to provide a liability shield, it isn’t enough. You also need to be proactive in maintaining that protection. In this article, we’ll go over some of the things you need to do to keep your personal assets out of the reach of potential creditors.
Why Does it Matter?
Bottom line, we live in a litigious society. As a business owner, you’re already assuming significant economic risks by opening your business. By properly managing your legal risks through the proper use of a Limited Liability Entity, you minimize the chances that legal claims will threaten the health or existence of your business, or even threaten your personal finances.
Let’s look at a quick example. Let’s say you’ve saved up $100,000 and you decide to invest $50,000 of it into a tree-trimming business. In the first case, you operate the business as a sole proprietorship rather than forming a Limited Liability Entity. In a parallel universe, you form the business as a Limited Liability Entity. In both cases the business is worth $50,000, and you keep the other $50,000 in the bank in a personal account.
One day, one of your employees negligently fells a tree, causing it to crash into the customer’s house, resulting in $100,000 worth of damage. As a sole proprietor, you are your business, and vice versa. As a result, the homeowner can go after the $50,000 business as well as your $50,000 personal savings. You’re out $100,000. If, on the other hand, your business is organized as a Limited Liability Entity, the homeowner can go after the $50,000 business, but your $50,000 in personal savings are beyond the reach of the homeowner. In both cases you lose the business, but in the second case the $50,000 you have in the bank are beyond the reach of the homeowner.
Why Does it Work This Way?
As a general rule, in our legal system you’re only responsible for the damage that you cause, not for the damage caused by another. Sounds fair, right? If your neighbor gets into an accident, he pays, not you. The same applies if he’s your best friend, your brother, or even your twin. The person who causes the harm pays for the harm.
When you form a Limited Liability Entity, you’re creating a distinct legal “person.” Even though the Limited Liability Entity can only act through natural, living people, its debts and liabilities are its own, not those of its owners. (This presumes that the owners are not at fault themselves, a topic for another discussion.)
If we look at the above example again, it hardly seems fair that the homeowner was limited to collecting $50,000 even though he incurred $100,000 in damages to his house. There are multiple policy reasons—generally related to encouraging economic growth—why a society would accept this tradeoff. That said, precisely because of the potential for injustice, courts have developed a doctrine known as “Piercing the Corporate Veil.” In a nutshell, it works like this: If you form a Limited Liability Entity, you are creating a separate legal “person,” and there’s no legal basis for holding you responsible for its debts. If, however, you disregard the separate nature of the business entity to the extent that it becomes your “alter ego”, then the courts will pierce the corporate veil and allow a creditor to pursue your personal assets to satisfy a claim against the business entity. The thinking is that if you didn’t respect the separate nature of the business, then why should the court?
The bottom line is that the business entity you choose to operate your business can protect your personal assets from the claims of the business’s creditors, but the form of the business alone isn’t enough to provide this protection—you also need to respect and maintain the business’s separate identity.
So How Do I Maintain the Liability Protection?
Here are seven must-dos to maintain the separation between your Limited Liability Entity’s assets and your personal ones. This list is not exclusive because piercing the corporate veil is a fact-specific exercise, but doing these things will keep you out of trouble most of the time.
- Don’t personally guarantee a loan to your company. This is easier said than done, especially if your company is just starting out and lacks a financial track record. Lenders may demand you personally guarantee loans they make to your company. As soon as you do, your personal assets are on the line, at least to satisfy the loan from that lender. (The protection will still be good against other claimants.) If possible, try to limit your personal liability by pledging specific property items as security for the loan rather than the entirety of your personal assets.
- Keep your personal finances segregated from your company’s finances. Don’t commingle funds in either direction. Keep separate bank accounts and scrupulously account for your business’s income and expenses separately from your own. Remember that your Limited Liability Entity’s a separate legal person, and you need to treat it as such. You want to keep the line between your personal finances and your company finances as bright and clear as possible.
- Execute and abide by robust governing documents: corporate bylaws (in the case of a corporation), an operating agreement (in the case of an LLC), or a trust agreement (in the case of a VBT). As part of maintaining a separate identity between you and your company, your governing documents should define the circumstances in which you are able to take money out of the company, either in terms of income or loans. The same applies for money going into the company. You need to follow the steps outlined in the governing documents and document the steps you took with each transaction. Although the Virginia legislature intended the LLC and VBT structures to require fewer “corporate formalities,” leaving a simple paper trail to explain why and how you made your decisions will go a long way toward defeating a claim that your company is merely your “alter ego.” This documentation can consist of fill-in-the blank forms that require minimal effort on your part but go a long way toward maintaining your personal identity and that of your Limited Liability Entity separate and distinct.
- Adequately capitalize your business. You should keep enough funds in your company to maintain its ongoing viability. How much money this is and how many months’ worth of funds you need to maintain an adequate operational cushion will vary from industry to industry as well as other factors such as firm size, seasonal activity, potential risks, etc. As a general rule, though, you’ll want to capitalize your business in an amount equal to your industry peers.
- Maintain adequate insurance coverage. Again, this will be industry-peer and activity specific, but a court will not look favorably on a company owner who took risks without taking out adequate insurance to hedge against foreseeable damages. Your insurance agent should be able to provide you reasonable industry standards.
- Run a business, not a scam. As a catch-all category, courts are not inclined to extend liability protection to people who are engaged in fraudulent, deceitful, or otherwise under-handed business dealings and expect to skate simply because they did so through a Limited Liability Entity. While a Limited Liability Entity will protect your personal assets from legitimate business decisions that didn’t pan out as you hoped, or due to declining market conditions, etc., it will not protect you from intentional wrong-doing.
- Keep your Limited Liability Entity registration up to date. Although the filing requirements, including fees and due dates, differ slightly between different entity types, in every case you’ll need to pay an annual registration fee to the Virginia State Corporation Commission. Failure to do so will cause your Limited Liability Entity to be dissolved and when that happens your liability protection will disappear, even if you continue to abide by the above standards.
In summary, business owners can protect their personal assets from claims against their businesses by establishing an appropriate Limited Liability Entity, but the form of the company alone doesn’t provide the desired protection. The business owner also needs to operate the business in a manner to take full advantage of the protections offered.