#1 Reason: Liability Protection!
LLCs can be an odd thing to understand, so take a few minutes and let me clear up any misconceptions and help you know once and for all how to use them throughout your business journey.
Entities can be tricky to wrap your head around. Why? Well, they are essentially made up. Unlike your car, your dog, or your clothes, these “legal fictions” can’t be touched. They’re conceptual. They exist only because we all agree they exist.
Business entities like corporations and limited liability companies may appear confusing at first, especially when you’re just starting out in your own business venture. But, bear with me and you might realize they aren’t as elusive as you first thought. I’ve been a business attorney for the better part of a decade and have helped hundreds of businesses, and I can tell you that you will thank yourself later for taking the time now to learn about business entities and get it right from the start.
To me, the entity conversation is an exciting time because it is often the first real step towards starting a business. A lot of planning and daydreaming precedes it, but most people that spend the time and money to choose an entity are serious about their business and are finally taking the leap! I want to help you make that first step with confidence.
Understanding Entities and Why They Exist
What do a freelance graphic designer with an LLC and Walmart have in common? The answer is simple: they both exist because they are based on a business entity that gives them the legal structure to operate their businesses.
That’s what’s so powerful about business entities. They can accommodate the business needs of a single-person, online-based company that clears $20,000 a year in profit, or a large, multinational corporation like Walmart, which employs over 2 million people and rakes in almost $500 billion per year in gross revenue – and everything in between.
The purpose of the entity is to encourage you to start and invest in your business without risking everything you own. By having a business entity, you separate yourself from your company in a way that takes much (not all) of the risk off of you personally.
It’s win-win. Society benefits as jobs are created, new products and services are available in the marketplace, and the economy grows. You benefit as you get to live your dream of being a business owner.
We take this protection for granted now, but let’s put it in perspective. For most of human history, business entities did not exist. There was no separation between the business owner and business. So if you borrowed money to start a bakery, for example, and it failed, you would personally be responsible for that failure. That meant selling off your house, your land, your chickens, or whatever else you personally owned, to settle debts associated with the business failure. And that’s if you were lucky; there was even a time where you could end up in prison or enslaved by your creditor.
In short, the consequences for failure back then were severe. You had to risk a lot – including your very freedom – to start a business. Does this sound like a world where you want to start a business? I don’t think so.
Fast forward to modern times where we can control how much and what we risk when starting a business (if planned correctly). Through a combination of federal tax law and state statutes, everyone in the U.S. has the opportunity to start a business to benefit themselves and others without taking on more risk than one is comfortable with. Yes, you might lose money if your business fails, and you will lose the time you put into it, but nothing more. Building your own business from the ground up gives you the opportunity to create great wealth, be your own boss, build a legacy, and make your mark on the world.
Business Entity As One Line of Defense In Risk Management
As stated before, business entities reduce risk but they don’t eliminate it entirely. They are just one piece (albeit a major piece) of the puzzle when it comes to protecting yourself. Let’s look at the others, and how the entity fits in.
Here’s what you need to reduce the risk you and your business take on:
Together, these four things create levels of protection around your business that stop problems from happening in the first place and help you manage them when they do arise. They also help keep you and your personal assets separate from your business. In other words, have these things in place, and if your business tanks, you won’t have to sell off your chickens to pay your debts.
Your first line of defense is Conduct. This has to do with how you treat your customers, vendors, and employees. This is not a legal concept, but I can’t stress how important it is. How you conduct yourself in business matters because people are more likely to take legal action against those who have behaved rudely, unprofessionally, and unethically. Behave like a professional and treat people with respect, and you’ll avoid many problems, I promise.
On par with Conduct is Contracts. Contracts matter because they give you legal recourse if something goes wrong, but more importantly, they help avoid problems in the first place by clearly laying out expectations for all parties involved. Both Conduct and Contracts
The next line of defense is Insurance. Business insurance is too wide a subject to go into here, but suffice it to say, you will likely want or need some, depending on what kind of business you’re running, whether you have a physical location and many employees or whether you work at home by yourself. I recommend you speak to someone who does business insurance to find out what’s necessary versus what’s nice to have.
The last and final line of defense is the business Entity you’ve chosen. The rest of this guide will go into how each type of entity offers that protection and how to determine which is the right fit for you.
What Is “The Corporate Veil”?
You’ve probably heard this term before. The “corporate veil” describes how an entity, like an LLC or corporation, protects your personal assets. When you hear the phrase “piercing the corporate veil,” it refers to a plaintiff’s lawyer trying to access money outside the business – usually personal assets, or assets of another business you own. Piercing the corporate veil sets aside the personal liability protection of the entity to reach you personally.
In other words, piercing the corporate veil is a bad thing. As a business owner, it’s crucial to understand how you can protect yourself from having a plaintiff’s lawyer pierce the corporate veil of your business.
The idea here is that the state will provide you with this protection but, in return, you must prove that you are actually a business and are operating the business in good faith to take advantage of these protections.
Don’t Commingle Funds
Commingling funds happens when a business and personal account are not separated but are mixed together.
To prevent this situation, follow proper accounting procedures. Never use your business bank account for personal reasons. Only business-related income and expenses should be going and in and out of that account. Otherwise, you are risking commingling.
Maintain Corporate Records, Status, and Formalities
It’s not enough to just file an LLC with the Secretary of State and forget about. Make sure you stay in good standing. This means paying fees that your state requires and updating them when you change addresses. You should also have formal documents like operating agreements and bylaws. If you are a corporation, you are likely required to hold meetings, keep minutes, and utilize mechanisms like resolutions. If you are an LLC, you likely have fewer record keeping requirements. The lesson here is that you must act like a business on paper.
Don’t Use Your Personal Signature On Documents
You go through all this effort to set up your LLC and maintain proper accounting and business structures, but then you sign documents with just your name. This means you are personally signing. Instead, start signing as a member of your company. It looks like this: “Wesley Henderson, as Managing Member, Drafted Legal, LLC.”
(Note: There are times where you will be asked to personally guarantee things like a loan or a lease agreement. Only sign personally if you intend to be personally liable and put your personal assets on the line.)
It Takes Effort
You won’t gain maximum protection from your business entity just by setting it up in the first place. You need to continually and consistently look and act like a business on paper and in practice.
Better yet, do all 3 all at once!