Shielding Your Personal Assets from Business Creditors

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During startup — before most entrepreneurs have a healthy cash flow — small business owners can be crippled by the ever-present risk of claims against their assets by trade vendors, the landlord, the bank lender, and even personal injury plaintiffs. This article discusses some of the legal entities that can help business owners build a personal asset shield.

During startup —  before most entrepreneurs have a healthy cash flow — small business owners can be crippled by the ever-present risk of claims against their assets by trade vendors, the landlord, the bank lender and even personal injury plaintiffs. Though an entrepreneur's business assets must be exposed to these claims, personal assets — homes, cars and bank accounts — can be protected against creditor lawsuits. But how, exactly, does an entrepreneur build a personal asset shield?

Several legal entities can help business owners accomplish this. Unlike partnerships and sole proprietorships, which expose personal assets to liability, these entities limit the liability for business losses to the assets placed in the business.

There are three limited liability entities available to entrepreneurs: traditional corporation, limited partnership and limited liability company (LLC). It's easy enough to start one of these entities by submitting the proper paperwork to the state secretary and obtaining a name and tax identification number, but many small business owners overlook the ongoing legal requirements necessary to maintain limited liability protection.

The "piercing the veil doctrine" requires that a business must at all times be run as a corporation — a legal person separate and distinct from its owner(s) — or the "veil" of the corporation will be "pierced," exposing the business owner's personal assets to liability. These ongoing requirements are similar for corporations, partnerships and LLCs, and are easy to follow.

Three formal tests used by the courts to determine if a small business is being run as a corporation are: commingling of funds, absence of corporate formalities and minimum investment at risk. There are several steps entrepreneurs should take every day to ensure that their businesses pass those tests:

  1. Commingling of Funds

    Your corporation should have its own, separate bank account that is used only for paying corporate bills. All business income must be deposited into this account first, and personal expenses must never be paid from this account. For personal spending money, have the corporation give you a paycheck that you can deposit into your personal account.

  2. Minimum Investment at Risk

    Your firm should have enough assets and insurance to cover the debts anticipated for your type of business.

  3. Corporate Formalities, Such as Signing Documents

    When you sign any document for the corporation, including bank loans, purchase invoices and service contracts, don't sign just your name. Documents should be drawn in the name of the corporation, with your signature and title. For example:

    New Business, Inc.

    by: _____________________
    Susan Q. Entrepreneur, President

Even if you follow these signing rules, you're still personally liable for anything you sign before your corporation is incorporated legally. The corporation can agree to pay any personal contracts signed before incorporation, but that doesn't limit the other party's ability to collect on the contract from the person who signed it when no corporation existed — you.

Your business must present itself to the public as a corporation. Business cards, stationary, forms and signs should make it clear to creditors that they're dealing with a corporation. For example, include the abbreviation "Inc." or the word "Incorporated" in your advertising. If you operate under a d/b/a (doing business as) name that's different from the name of your corporation, make sure to file the fictitious or assumed name with your state corporate office. On business cards, be sure to state your corporate title — president, vice president or general manager — wherever your name appears.

Be sure that the owners and directors of the business, and those they appoint to run it, pass resolutions authorizing officers and other employees to take various action. These resolutions can be as specific as giving one-time permission for an officer to approve a bank loan, or as general as appointing a new person to all of the duties of corporate office. Copies of these resolutions are required by many banks and leasing companies to protect them against loss. Without them, a corporation can say that the person signing the contract didn't have the authority to bind the corporation.

YOU'RE NEVER TOTALLY PROTECTED

Regardless of the type of entity you choose, bank lenders may require personal guarantees from shareholders and their spouses. Additionally, those actually operating a business are, by law, personally liable for certain claims, regardless of whether there is a corporate liability limit or not. For example, you can be held personally responsible for violations of Environmental Protection Agency, Occupational Safety and Health Administration and pension laws that could have been avoided through your day-to-day control of the business. No limited liability can protect a business owner from criminal responsibility or against penalties for stealing sales or withholding taxes.

You can't get limited liability protection simply by adding Inc., LP or LLC to your name and calling yourself a corporation; you must file the necessary paperwork in your state's capital. More importantly, you must run your business as a corporation on a day-to-day basis. Incorporating as soon as you contemplate a new business venture — then playing by the rules — is one sure way to help protect your personal assets from organizational debts.

About the Writer: Stanley P. Jaskiewicz is an attorney with the Philadelphia law firm of Spector Gadon & Rosen. A member of the firm's Business Law Department, he assists businesses on a wide range of legal matters, including contract law, secured lending, negotiated acquisitions, intellectual property and regulatory issues. This article originally appeared in the Summer 1996 issue of Entrepreneurial Edge.

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