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Three Ways to Lose Personal Liability Protection -- And What to Do About It

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Three Ways to Lose Personal Liability Protection -- And What to Do About It

By BarbaraWeltman, Guest Blogger
Published: December 29, 2009

You may have incorporated your business or formed a limited liability company (LLCs) with the idea of obtaining liability protection for your personal assets. Think you’re protected? Think again. You may not have the protection you expect.

Here are three traps that can put your personal assets at risk and how you can protect yourself.

1. Sloppy business practices
Good business practices require that you keep good books and records on your business activities and that you separate your personal finances from your business finances. Unfortunately, in some small companies, owners treat their business’s bank account as their personal pocketbook, dipping into it freely. If the company owes money, a creditor can argue that the corporation is a sham and that your personal assets should be available to pay outstanding claims. When a creditor can successfully persuade a court of this argument, it’s called “piercing the corporate veil.” (The same thing can happen to LLCs.) In this case, you lose any personal liability protection.

What to do. Follow formalities. Respect your business entity and comply with the rules in your state when it comes to annual meetings, state filings, and other activities. For example, corporations must hold an annual meeting, even if there’s only one owner. Record the minutes of the meeting and save them in your corporate book. LLCs usually aren’t required to have an annual meeting, but doing so (and recording what was covered) can go a long way in showing that there is a separate entity.

Set up a separate business bank account and business credit card. Don’t transfer money between the business and owner without having a business reason and recording the transaction. For example, if an owner wants to take a loan from his or her corporation, this should be authorized by the board and recorded in the corporate minutes.

Also, make sure that your company is sufficiently funded at the start. Gross underfunding can be evidence that the entity is merely a shell intended to defraud creditors.

2. Poor payroll deposit practices
If your business has any employees, you’re required to handle employment taxes properly. This means withholding income taxes and the employees’ share of Social Security and Medicare taxes (FICA), as well as paying the employer’s share of FICA and federal and state unemployment taxes. The employees’ withholdings for income taxes and FICA are referred to as trust fund taxes because you are holding the employees’ money for their benefit until you deposit the funds with the government. If you willfully fail to deposit these taxes, you can be subject to a 100% tax penalty as a responsible person. In essence, regardless of how you’ve set up your business, you can be personally liable for all of the trust fund taxes you failed to deposit.

What to do. The easy answer is simply deposit the taxes in full and on time. Sometimes, however, you may fall short. You can avoid the trust fund recovery penalty, which may be collected from your personal assets:

  • Determining whether you are a “responsible person” who willfully failed to deposit trust fund taxes. A responsible person is a person who has the duty to perform and the power to direct the collecting, accounting, and paying of trust fund taxes. This includes an officer or employee of a corporation, a corporate director or shareholder, or any other person with authority and control over funds to direct their disbursement. Willfulness in this situation means you are aware of the outstanding taxes and chose to ignore your responsibility; no evil intent or bad motive is required.
  • Paying trust fund taxes before other creditors. When cash is tight and you are forced to choose where to apply your funds, pay the government first. Opting to pay a supplier, landlord, or other creditor while any trust fund taxes have yet to be deposited amounts to willfulness.

You can learn more about employment taxes and the trust fund recovery penalty from the IRS.

3. Borrowing arrangements
If you need money and seek a commercial loan, understand the realities of the lending process. Loans to small businesses usually require the owner to give his or her personal guarantee before the company can receive any money. This means that if the business fails to repay the loan, the lender can look to the owner’s personal assets to satisfy the debt.

Which owners are at risk? For those applying for an SBA-guaranteed loan, a personal financial statement, SBA Form 413 must be completed by any limited partner (presumably this would cover a limited liability company member) owning at least a 20% interest and any shareholder owning at least 20% of the stock in the corporation. Such individuals are required to give their personal guarantee for any loan that the company secures (there may be exceptions for commercial mortgages where the loans are secured by the property). The lender can seek payment from any one or more of the owners who have given personal guarantees.

What to do. Usually, the requirement that all owners with at least a 20% interest give a personal guarantee is not negotiable for most types of small business loans from commercial lenders. But you may be able to limit or avoid personal exposure:

  • Seek to secure the loan where possible by company assets, such as realty and heavy equipment. Usually, computers, office furniture and other light equipment can’t be used as collateral for a loan to relieve the owner of having to give a personal guarantee.
  • Look for financing from non-commercial lenders, such as family and friends, who may not require a personal guarantee.
  • Build business credit so the company can obtain a loan without your personal guarantee. Usually, this takes time and the business must achieve a certain revenue benchmarks.
  • Apply for grants rather than loans. Grants are “free money” that does not have to be repaid. For example, Amber Grants from *WomensNet.net make quarterly grants of $500 to women start-ups. Find grant opportunities through Grants.gov.
  • Obtain supply or vendor financing for purchases. These loans generally don’t need an owner’s guarantee.

Note: As in the case of commercial loans, you may also have to give a personal guarantee on commercial leases and business car loans/leases.

*Not a government website.


Barbara Weltman is a respected corporate speaker, contributing editor, author of more than a dozen books from major publishers, sought-after expert media source, newsletter publisher and, more than ever, a trusted advocate for small business owners. Barbara is passionate about helping the small business community and fostering the entrepreneurial spirit. She enjoys serving as a true small business expert, teaching people how to start a business and expand their current enterprises.

About the Author:

Barbara Weltman

Guest Blogger

Barbara Weltman is an attorney, prolific author with such titles as J.K. Lasser's Small Business Taxes, J.K. Lasser's Guide to Self-Employment, and Smooth Failing as well as a trusted professional advocate for small businesses and entrepreneurs. She is also the publisher of Idea of the Day® and monthly e-newsletter Big Ideas for Small Business® and host of Build Your Business Radio. She has been included in the List of 100 Small Business Influencers for three years in a row. Follow her on Twitter: @BarbaraWeltman.

Comments:

Usually, the requirement that all owners with at least a 20% interest give a personal guarantee is not negotiable for most types of small business loans from commercial lenders
Thank you both for taking the time to comment. I'm very pleased you found the information helpful - that's great!
Two points. 1) I would encourage folks to use personal credit cards over business credit cards. Business credit cards don't build that much "business credit," and you are correct, the small business owners are going to get stuck signing personally anyway. The laws limit the liability of a personal credit card if it lost or stolen. Those same lays don't apply to business credit cards, and a lost or stolen business credit card is a lot more serious. Simply divide the expenses on the personal credit card statement between personal charges and company charges. Write two checks, one personal check to cover the personal charges and one company check to cover the company charges. The IRS and courts will absolutely say you have not commingled you money between the business and personal. 2) A husband and wife should not be co-owners of the business. If they are, both spouses will end up being on the loans as guarantors. Keep one spouse out of the business (except as a possible employee), and make sure only one spouse signs as a guarantee on a business debt. Keep personal assets in the name of or living revocable trust of the non-business spouse. That way those assets may not be available if the business goes down. This works very well in common law states, but not so well in community property states where husband and wife are considered an inseparable economic unit.
Thank you both for taking the time to comment. I'm very pleased you found the information helpful - that's great!
Your article is very helpfull, more people should read it before it´s too late
This is excellent information, Barbara. Thank you.

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