LLCs Are More Limited Protection Than Many Entrepreneurs Realize

LLCs Are More Limited Protection Than Many Entrepreneurs Realize
Image credit: Joe Gratz | Flickr

Lisa has left her job as a graphic designer at a recognized firm to start her own business. She enjoys the work she does but not the environment of that established firm.

Deciding she'd rather be her own boss, she's ready to take on clients but thinks she should create a formal business entity before she starts work for her new clients. She has no plans to hire employees and will be doing all of the graphic design work herself. She's scared of what liability she'll be open to as a sole proprietor, so she thinks forming a limited liability company will help her cover her own assets.

I've met with many solo entrepreneurs and service providers as a business attorney. Often they share Lisa's misconception that forming an LLC will protect them personally. They're usually surprised when I tell them they're wrong. An LLC probably won't save an entrepreneur in future lawsuits over services they personally provide or products that they personally make or manufacture.

Although an LLC imposes fewer compliance and regulatory requirement than corporations, forming and operating an LLC can still be a hassle because of the formalities it requires. In the United States, a limited liability entity is a separate legal “person” distinct from its owners. This means, among other things, that the LLC needs its own bank account and set of books. If an LLC's owners don't respect the LLC as a separate legal person, a court may be willing to disregard its existence and impose what would have otherwise been the LLC's liabilities upon the business owners, personally.

Related: The 5 Biggest Tax Differences Between an LLC and Corporation

That's why I urge these entrepreneurs to get true clarity on their desires and needs. If you're considering forming an LLC, ask yourself these questions:

  • Will you be selling products manufactured by someone else?
  • What plans do you have for expanding your business?
  • Will you hire employees in the near future?
  • Will you be seeking financing to purchase property or equipment?
  • Will you be buying property or other assets under a business name?
  • Do you own property or other assets you'll want to protect?

Related: What to Consider When Deciding Between Forming a Sole Proprietorship or LLC

If you're going to be selling products manufactured by another business or you’re going to hire employees, contractors or subcontractors, you’ll probably still benefit from structuring your business as an LLC. An LLC can often limit liability caused by the negligence or misdeeds of a business’ employee, and those liabilities associated with the debts of the business.

When you have employees as a solo entrepreneur, you're liable for the actions of your employees. However, if your business is structured as a limited liability entity, such as an LLC, liability for your employees' actions most often stops at the LLC and does not extend to you, the business owner, personally.

Related: Pay Attention to Personal Liability

If your business will need outside financing to buy property or equipment, you may wish to protect your personal assets by forming an LLC. An LLC can protect you so long as you do not personally guarantee the debt obligations of the LLC. If, however, you do personally guarantee debts, such as a mortgage or equipment financed by the LLC, you can be held be personally responsible for those debts. As a result, it is very important to understand whether you are personally guaranteeing any debt.

While business owners who personally provide services are always responsible for their own actions and cannot hide behind limited liability to avoid the legal consequences associated with harm or damage that they personally cause, there are many clear advantages to forming a limited liability entity.

If you're considering forming an LLC but not sure whether you'd benefit, talk to a lawyer.

Related: Think Incorporating Will Protect Your Personal Assets? Not in These Cases.