Protecting Personal Finances From Business Creditors
You don't need to open an offshore bank account to protect your personal finances from business creditors.
Hopefully, your business won't be the target of a lawsuit or be at the mercy of lenders who say you owe them money. But it can happen, and the best protection is to be prepared.
Here's a primer to make sure your personal finances are protected from anyone with an eye on your business.
Structure Your Business
The easiest way to protect your personal finances from business creditors or from company-related litigation is to create your company as a separate legal entity.
"Form some type of entity that would be viewed as though it were a separate person in the eyes of the law so any liabilities, debts or financial repercussions that arise because of the business apply only to the business,' says Jean Batman, a business attorney with Legal Venture Counsel in San Francisco, and author of Advising the Small Business.
Some options to consider:
- Limited Liability Company, or LLC: An LLC is the most simple and flexible business entity choice. Structured with some characteristics of corporations, partnerships and sole proprietorships, an LLC will, as the name states, provide limited liability to the owners.
"The liability of the owner is limited for obligations of the business to the value of the business, or what they have invested in the business, and they incur no personal liability, assuming their actions are within the scope of the business, properly authorized by the business and they have not signed a personal guarantee," says Barry Jones, a tax attorney with Wise Carter Child & Caraway in Jackson, Miss.
To create an LLC, visit your state's office of the Secretary of State or the Treasury. You'll select a name for the LLC, file the required paperwork and pay the fee--usually between $100 and $800, depending on the state.
LLCs offer tax advantages, as profits are taxed like partnerships, with so-called "pass-though" treatment for profits and losses. That means it allows the income or loss generated by the business to be reflected on the personal income tax return of the owners.
- S Corporation: Like LLCs, S corps--so named for Subchapter S of Chapter 1 of the Internal Revenue Code--allow for pass-through taxation of income and losses for federal purposes. Also like LLCs, S corp owners are typically not held personally responsible for the debts or liabilities of the business.
The S corp has certain disadvantages, Jones says.
"Under current law, there are a number of technical rules that restrict the type of shareholder, number of shareholders, classes of stock and other restrictions," he says. "The failure to adhere to the myriad of rules, even inadvertent, will cause the S corp to lose its S corp status and be treated as a C corp."
S corps can also be created through filings with your state's Secretary of State or Treasury Department, and like LLCs, filing fees vary. File Form 2553 with the IRS, too.
Separate the Money
Whether you choose an LLC or an S corp, it's essential that you keep the business money and your personal money separate. (Read more on how to separate assets here.)
"The entity has to have its own bank account and documentation for what goes in and out to show it's not being used for personal purposes," says Batman.
While you may be tempted to forgo bank fees or try to keep your paperwork to a minimum by consolidating your business and personal accounts, doing this may open your personal accounts to business liabilities.
Your LLC or S corp will receive its own Federal Tax Identification Number (TIN), so your Social Security number should not be linked with business accounts.
"Deposit all business receipts and pay all business expenses only with the business account, and never pay personal expenses using the business account," says Jones.
For a sole proprietor or single-member LLC using a Social Security number, consider using a "doing business as" name for the business, Jones says.
When you create your company, pay special attention to situations in which state law may disregard your corporate entity, therefore exposing the owner's personal assets. Typically, cases involving fraud, the co-mingling of company and personal assets, or using corporate assets for personal use (such as paying personal bills from the corporate account) could lead to trouble.
"In such cases, the corporate form is not respected by the court, and the shareholder is subject to personal liability," Jones says.
Of course, when you're trying to get your business off the ground, the company doesn't have any credit of its own. There will be times when your business won't be granted loans unless you personally guarantee the obligation. That's a tough one: Either you put up your personal assets or your business doesn't get what it needs to expand.
"It's common that to get a lease, the owner has to co-sign," says Batman. "In most cases, they've guaranteed company credit cards, too, so any of those things give rise to personal liability for the company's obligations."
You may not be able to avoid it; just understand the risk when you make a personal guarantee for your company.
If a business goes belly-up and files for bankruptcy and it has been structured as a separate entity, an owner's liability should be protected.
Many business entities will first file a Chapter 11 bankruptcy (reorganization). Once the bankruptcy petition is filed, an "automatic stay" prevents creditors from attempting to collect from the business, and the business falls under the bankruptcy court rules, Jones says.
"The goal of the Chapter 11 reorganization is for the business and creditors to negotiate a plan to provide payment to the creditors and allow the business to emerge from bankruptcy and continue to operate,' he says. "If a feasible plan cannot be formulated, the bankruptcy court will oversee the orderly liquidation of business assets and payment of creditors."
If you as the owner have signed any personal guarantees, the business bankruptcy will not protect your personal assets. You may be forced to declare bankruptcy, too.
If it comes to that, at least your retirement assets should be safe. So-called qualified plans, such as 401(k)s, are protected in bankruptcy under federal law up to $1 million. Check your state laws to determine IRA protections.
Think About Your Spouse
Many business owners decide to place ownership of assets in their spouse's name because they think it will provide some protection for the business owner. Sometimes it does. Other times it causes more problems.
Like in the case of divorce.
If you're not married yet, it may be wise to consider a prenuptial agreement, Batman says.
"The premarital agreement should make sure that if the marriage doesn't work out, the entrepreneur can keep the business," Batman says. "Otherwise it might have to be sold in order to be divided as an asset."
Another option, especially if both spouses have an interest in the business, is a buy-sell agreement, which spells out what would happen to the business if one spouse wanted out.
If you're already married, you can consider separate property agreements. This is a great protection for the spouse, so if there's a lawsuit against the entrepreneur, the spouse's assets wouldn't come into play, Batman says.
Also investigate the laws in your state. Some allow the establishment of a domestic asset protection trust, which is generally protected against creditors.
Have the Right Insurance
There are several kinds of insurance coverage that can protect both your personal and business assets.
- Umbrella liability coverage: This type of plan often has a business exclusion, but if you're ever sued and named alongside your company for negligence, it may protect you.
- General premises liability coverage: If someone falls in your store or office, this will protect the business.
- Ask your insurance pro: Your company may qualify for "errors and omissions" or "directors and officers" coverage, which would protect your business and its employees under a range of legal challenges.