Many small business owners and entrepreneurs seek limited liability protection for their new ventures, which is why they often structure their businesses as a limited liability company (LLC) or corporation. Limited liability protection enables these entities to enter into contracts and own assets, as the law recognizes them as separate from their owners. However, once you form your business, you’ll need to manage it properly to ensure you keep your liability protection.
7 ways you can lose limited liability protection
1. Putting personal assets up as collateral for business debts
One way business owners can lose their limited liability protection is by signing personal guarantees for their company’s debts or financial commitments. A personal guarantee is a legal agreement where a person—in this case, a business owner—promises that they will be personally responsible for the company’s debt if it is unable to fulfill its financial obligations.
Alternatively, creditors may ask business owners to pledge personal property as collateral for their financial commitments instead. This is similar to personally guaranteeing business debts, except a pledge of personal property offers up specific assets—such as a home—to secure the loan.
Making these agreements can blur the distinction between your business and personal finances, putting your liability protection at risk. Ideally, you should seek out alternative methods of financing your business before relying on these options. However, some first-time business owners have no choice but to cross this line, especially if they haven’t built up their business credit yet.
2. Commingling personal and business finances
Business owners can lose their limited liability protection by intermingling their personal and corporate funds in other ways.
Using a personal bank account for business transactions can compromise a business owner’s liability protection, which is why business experts generally recommend that first-time business owners open a separate bank account for their new venture. Using business funds for personal purchases (and vice versa) also makes it challenging to maintain accurate financial records for your company.
If you commingle funds, creditors seeking repayment for corporate debts can argue that they can go after your personal assets because you and your company are one and the same.
3. Undercapitalizing your business
When a company is undercapitalized, it means that it lacks sufficient funds to continue operations or fulfill its financial obligations. And if a business owner regularly takes distributions from the company but fails to leave enough funds for its operations, creditors may seek to recover the owner’s personal assets to satisfy the company’s debts.
Undercapitalization by itself usually isn’t enough for a business owner to lose their liability protection, especially when it comes to a new venture. However, if a court determines that the owner also regularly commingles funds or commits fraud, for instance, they become significantly more exposed to personal liability.
4. Failing to pay business taxes
If a limited liability company or corporation fails to pay its taxes, the Internal Revenue Service (IRS) may find the business owner personally liable for it, even if the company has been dissolved.
Of course, this is also in addition to any fines or penalties incurred by failing to pay the taxes in question. Failing to fulfill your tax obligations as a business owner can result in charges of tax evasion or lead to your company losing its good standing with the state.
5. Treating the company as an extension of yourself
Setting your business up as an LLC or corporation means that you intend for your company to be treated as a separate legal entity from you, the business owner. So, if you treat your business as an extension of yourself rather than a separate entity, you could lose liability protection if a court rules that the business doesn’t exist since you’re still doing business as yourself.
This is known as alter ego liability, where a business owner has such complete control over the company’s operations that it becomes difficult (or even impossible) to separate the owner’s business from their personal affairs. This might look like using business funds to pay for personal expenses, or using the company car for a vacation in New York.
6. Committing fraud or personal wrongdoing
Business owners can also be held personally liable for their company’s financial obligations if they commit fraud—for example, if they break the law or misrepresent their company’s finances with investors or lenders.
Personal liability protection doesn’t shield business owners from the consequences of harmful or negligent actions either. If they know their business is causing harm, but put in little to no effort to correct the situation, they can be held personally liable for their LLC or corporation’s actions.
Say a business owner—let’s call him Mr. Smith—has hosted a happy hour for his team at the local bar, but his employee Jason still has to deliver goods to a customer after the event. If Mr. Smith allows Jason to drive the company vehicle while he’s drunk, and he hits a pedestrian while driving, the pedestrian can sue both the business and Mr. Smith.
7. Piercing the corporate veil
Creditors can sometimes go after a business owner’s personal assets by forcibly removing the company’s limited liability protection.
In this process, known as piercing of the corporate veil, a court can disregard a company’s separate identity from its owners and hold them personally responsible for the company’s debts and liabilities. This typically occurs when a business owner blurs the line between themselves and the business, or when there’s evidence of fraud, negligence, or intentional wrongdoing.
What is piercing the corporate veil?
Piercing the corporate veil is a legal term that describes the act of a business owner losing the limited liability protection afforded by their LLC or corporation. They then become personally liable for the company’s debts or obligations.
If a court rules that the corporate veil has been pierced, it disregards the separate legal identity of the business. Creditors can seize a business owner’s home, personal bank funds, investments, and any other personally owned assets to fulfill the terms of their loan.
7 tips to help small business owners preserve their limited liability protection
Even if your company grants you personal liability protection, it’s important to remember it can be stripped away if you blur the lines between yourself and your business. To ensure you don’t expose yourself to personal liability, follow these seven tips.
1. Register your business as a corporation or LLC
In order for your business to be recognized as a separate legal entity, you’ll need to register it as such. Only certain types of business entities, such as corporations and limited liability companies, offer liability protection to their owners. Disregarded entities, such as sole proprietorships and general partnerships, aren’t treated as separate entities from their owners and, thus, don’t have liability protection.
So, in the US, you would need to form your business as an LLC, C corporation, or S corporation. Then, complete all the necessary steps to establish the company formally. This includes applying for an employer identification number (EIN), opening a business bank account in your company’s name, and getting any permits or licenses needed to operate in your jurisdiction.
Determine which state you’ll register your business in (most new business owners choose the state they live in), and visit their Secretary of State website for information on their business formation process and requirements.
2. Maintain your business entity’s requirements and corporate formalities
If you haven’t already, create a clear plan for your business, including how it will operate and handle potential issues, and stick to it. Following your business plan and working toward your business goals can help show that you treat your company as an independent entity (more on this in the next section) and that you aren’t acting recklessly.
Regularly verify that your business is complying with all applicable laws, corporate formalities, and other relevant obligations. Expect to file annual reports, pay yearly taxes and fees, hold annual meetings, and update your operating agreement or corporate bylaws regularly. If you hire employees, stay on top of your federal and state employment taxes, as well as other related obligations.
If you own multiple businesses, make sure you stay up to date with each entity’s corporate formalities and other requirements.
3. Treat your business as an independent legal entity
When doing business, act as a representative of your company rather than acting in your name. Enter business contracts and purchase property or other corporate assets in your company’s name. Formal business documents issued by your company—including contracts, invoices, and purchase orders—should have the business name, contact information, and other details on them.
You should also keep meticulous records of all your business activities. Document any major business decisions you make. Record meeting minutes and keep them in a secure location along with the company’s financial statements, legal documents, and other documents.
4. Maintain separate business and personal financial accounts
To maintain limited liability protection, keep your business and personal bank accounts separate. Personal purchases should be made with personal funds, and business expenses should be covered with business funds. Your company should have its own bank accounts, debit cards, credit cards, and financial records. If you use financial software or apps like Venmo or Zelle, the business should have its own accounts as well.
Business owners with multiple companies should also keep each entity’s funds separate or risk losing the personal liability protection they afford. This includes financial accounts, equipment, real estate, and other assets. Keep complete financial records—including income, expenses, assets, and liabilities—for each company.
To help prevent commingling funds, consider using separate banks for your personal finances and business earnings.
5. Avoid putting personal assets up as collateral
New business owners or those without a strong track record may find it challenging to secure an initial business loan without providing personal guarantees or using personal assets as collateral. If possible, you should avoid this route to prevent blurring the lines between you and your venture, and thus piercing the corporate veil.
Instead, work on establishing your business credit (and improving your creditworthiness, if needed) so you can avoid making these agreements.
6. Establish business credit
To establish your business credit, follow these two steps. First, apply for a DUNS (Data Universal Numbering System) number. This is a unique nine-digit number that many businesses and potential creditors use to review a company’s credit profile and financial health. They’ll then use that information to determine whether they want to work with you.
You can obtain a DUNS number for free through Dun & Bradstreet, a widely used business credit bureau, by visiting its website.
You’ll also want to apply for a business credit card, as this will allow you to start building credit for your company. And the sooner you do so, the better. Having a longer credit history can help you achieve a higher credit score, as long as you maintain the other aspects of your credit. So pay your company’s bills on time, regularly check your credit score, and maintain your personal credit as well.
7. Maintain adequate business capital
Do your best to ensure your company always has sufficient funds in its accounts to remain operational—whether this means setting aside a portion of the business income for future needs, taking out a loan when work slows down, or applying for a business credit card for unexpected expenses.
The amount you should keep in your business bank accounts will depend on the type of business you own. A company with an office, several employees on payroll, and many recurring monthly expenses will need more to operate than a home-based online service provider.
Make sure that the money you’ve earmarked for this purpose is designated to the business, not to you. Otherwise, you risk piercing the corporate veil and losing your limited liability protection.
Gusto can help
Once you determine that you need to structure your business as an LLC or corporation, you’ll need to change your mentality as a business owner, too. It becomes more important than ever to keep your business and personal affairs separate if you want to maintain the limited liability protection offered by your company.
However, keeping track of all the obligations and corporate formalities your business must follow can be overwhelming for a first-time business owner. That’s where Gusto can help. Our easy-to-use payroll software automatically calculates and files your payroll taxes every time you run payroll, so you don’t have to. Learn how else Gusto helps businesses run more efficiently by creating a free account today.
