Does Your Entity Choice Provide Personal Liability Protection?

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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When you set up a business, you may opt to incorporate or become a limited liability company (LLC) so that creditors can only look to the business, and not your personal assets, to satisfy their claims. This entity choice, however, only goes so far in providing protection for an owner's personal assets. There are certain situations in which an owner can continue to have his or her personal assets at risk because it is part of usual business practice or because of improper conduct by the owner.

Personal Guarantees

In order for a small business to obtain a loan, an owner is usually required to give his or her personal guarantee. This means that if the business fails to pay what it owes, the lender can look to the owner to make the payments. If the owner fails to do this, the lender can pursue collection action against the owner and ultimately obtain the owner's personal assets, such as a home, car, and savings account.

An owner's guarantee typically is required in these situations:

Commercial Loans

For example, in the case of a SBA-guaranteed loan, anyone owning at least 20 percent of the business is required to guarantee the loan.

Credit Cards

Obtaining a business credit card may depend on the owner's credit rating as well as his or her personal guarantee.

Leases

Landlords generally ask that an owner personally guarantee the lease.

Car Loans

If a vehicle is purchased by the business and the purchase is financed, the finance company will need the owner's personal guarantee.

Looking Beyond the Entity

A corporation is a separate being in the law; it can sue and be sued. However, creditors can disregard the corporation and look to the owner when the owner fails to treat the corporation as a separate being. This is called "piercing the corporate veil." (A similar action can result for LLCs.)

This can happen when an owner is careless about where corporate income is deposited — into the corporate account or directly into the owner's account. Similarly, paying corporate expenses from a personal bank account rather than the corporation's bank account can be used to show that the corporation is disregarded by the owner, so the creditor can look to the owner to satisfy the obligation.

What to do to avoid this result:

Keep Corporation Finances Separate from Owner Finances

Use a separate bank account and separate business credit card.

Hold Regular Board Meetings

Under state law, corporations usually are required to hold at least an annual meeting to approve compensation of officers for the coming year and other actions.

Maintain Corporate Minutes

Having a meeting isn't enough; put in writing any decisions by the corporation on actions it takes.

Trust Fund Liability for Certain Taxes

An employer must collect both income tax withholding and the employee share of Social Security and Medicare taxes (FICA) from employee wages and pay them to the government. If the employer is a corporation or LLC and the business fails to pay these taxes, an owner, officer, or even a bookkeeper in the right circumstances can be personally liable for 100 percent of the taxes. In the tax law this person is called a "responsible person."

Whether a person is a responsible person depends on various factors. No single factor is determinative. According to the tax law, these factors include:

1. The contents of the corporate bylaws.
2. The ability to sign checks on the company's bank account.
3. The signature on the employer's federal quarterly and other tax returns.
4. The payment of other creditors instead of the United States (such as paying vendors and suppliers).
5. The identity of officers, directors, and principal stockholders in the company.
6. The identity of individuals in charge of hiring and discharging employees.
7. The identity of individuals in charge of the firm's financial affairs.

One recent case illustrates the point. Joseph was the owner, president, and sole officer of a corporation. As the sole corporate officer, he was the only person who had the authority to write checks and pay the corporation's bills, taxes, and creditors. He had an obligation to withhold income and FICA taxes ("trust fund taxes") from the wages of the corporation's employees and remit the withheld taxes to the government, but he failed to do so. The court held him liable for the trust fund taxes. He didn't have the cash, so the government placed a lien on his home — his only asset. (His attempt to transfer the home to his wife to prevent this result was voided.)

A Better Way

Make sure that the business pays trust fund taxes before paying other bills. When there isn't enough cash to pay taxes and other bills, consider obtaining debt-restructuring assistance from a company such as Corporate Turnaround, so vendors will continue supplying goods and services with partial or delayed payment while the business pays its taxes in full and on time.

Final Word

Owners of corporations and LLCs should understand their obligations and restrictions so they can continue to maintain their personal liability protection to the fullest extent possible. When in doubt, talk with an attorney who is knowledgeable in this area of law.