How Does an LLC Protect Your Personal Assets?
- Last updated on . Written by Offshore Protection.
What is a Limited Liability Company?
A Limited Liability Company (LLC) is a type of corporate entity which provides liability protection to their owners (i.e., “limit liability”), in that the assets which are owned by an LLC are separate from the owner’s personal assets.
The easiest way to think of an LLC is that it is a hybrid between a corporation and sole proprietorship. Just like a corporation, it is seen as a separate legal entity, and therefore offers greater asset protection.
However, LLCs are akin to sole proprietorships and partnerships in that they are simpler to set up and run than a corporation. They are also “pass-through” tax entities which means that they do not pay taxes at the corporate level, but instead the owners are liable to pay taxes on profits and losses at the personal level.
Table of Contents:
- What is a Limited Liability Company?
- Using an LLC to Protect Your Personal Assets
- When does an LLC Not Protect Your Personal Assets?
- Measures to Take for Maximum Protection
Using an LLC
Limited Liability Companies have been widely used to protect personal assets from the risks incurred during the course of business. They do this by effectively creating a legal wall between the liabilities faced by the company and your personal assets.
If the company faces any unforeseen liabilities which arise through the course of business (e.g., lawsuits, creditor claims, bankruptcy, etc.), only the assets which belong to the company are at risk of being claimed, while the owner’s personal assets remain at arm’s length.
There are, however, exceptions and limitations to the level of protection that an LLC provides, which we will deal with later. Firstly, let us explore in more detail the various instances in which an LLC can help protect your personal assets:
1. When you use It as a vehicle through which to conduct your business activities
- If someone sues the business (or makes any claims due to negligence during the course of business), then the only assets which can be claimed are those which belong to the LLC, not your personal assets.
2. Your personal assets, bank accounts, and property cannot be included in any legal issues or claims pertaining to the LLC.
This applies even in the case that the assets held by the LLC are insufficient to meet the legal obligations. In order for an LLC to provide sufficient and maximum protection, it must be properly structured and maintained, and must be established before any lawsuit takes place.
3. They can also be used as vessels to protect your assets from personal liability.
- For example, one popular strategy utilised is to establish an offshore LLC which is not actively engaged in business (but acts simply as a financial vehicle) to which you can transfer your personal assets. This protects these assets in the event that you have a lawsuit or claim against your personal assets. In other words, not only can an LLC protect your personal assets from claims against the business, but they can also protect assets that have been transferred to the LLC from your own personal liability. This makes them highly versatile instruments for asset protection.
4. LLCs can protect you from being sued personally.
- An example is a freelancer or independent professional (e.g. doctor, lawyer, architect, etc.) who decides to set up an LLC through which to conduct their business activities. If they were to conduct those same business activities in their own personal name without the additional corporate layer, they would run a higher risk of being personally sued in the event of malpractice or damages arising in the course of business.
When Are Your Personal Assets Not Protected?
The liability protection offered by an LLC is in no way fool proof, and it is important to be aware of exceptions to the protection that it offers. The following scenarios highlight some of these exceptions:
1. Establishing It after a lawsuit has been filed or wrongful act has been committed:
For an LLC to be effective in protecting your personal assets, it must be established in advance. An LLC will not work to protect you from a lawsuit if it is formed after you have been sued or after the wrongdoing has taken place.
2. Making personal guarantees:
Another instance in which an LLC will fail to protect your personal assets is if you make any personal guarantees regarding company debts to a lender. In such a case, you can be held personally liable for the obligations if the company fails to meet them. This is also the case if you sign any contractual agreement in your personal name as opposed to the LLC’s name. The best practices to employ to avoid such a costly mistake are:
- Always be careful to make sure that you act in the LLC’s name and not your personal name. Never give personal guarantees or assurances, written or spoken. When you do sign contractual agreements on behalf of the LLC, make sure it is clear that you are signing as an agent of the LLC and that the LLC is the primary party in the contractual agreement.
- In the same regard, make sure that other employees and agents of the LLC do not act as representatives of you personally, only as agents of the LLC.
- Read all contracts and agreements carefully to avoid being caught unawares. Some loan documents and contractual documents may have hidden terms which create personal liability in the case of default. Such terms should be identified and avoided.
3. Piercing the Corporate Veil:
In some exceptional circumstances, courts may overrule the limited liability protection of an LLC and impose personal liability onto the LLCs owners. This happens when the court deems that the LLC is not actually a legitimate corporate entity and has been created for the sole purpose of protecting its owners from liability.
In short, you need to take the necessary steps to ensure that the LLC you have created is indeed a legitimate corporate entity, and not simply an extension of your personal activities. If the courts deem that an LLC is not actually separate for all practical purposes, then your personal assets could be at risk. This is known as “piercing the veil” of liability protection, and is something to avoid at all costs.
To avoid such an occurrence, make sure that all necessary corporate formalities are followed, that the financial affairs of the LLC are kept separate from its members, and that proper corporate bylaws are in place.
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4. Wilful Misconduct and Negligence:
It was mentioned that an LLC is recommended to avoid the risk of personal liability suits in the case of malpractice or damages which take place during the normal course of business. While this is certainly true to an extent, the protection that an LLC offers only goes so far. In the case of gross negligence or misconduct which causes harm or injury to others, an LLC may not be able to protect the member.
Additionally, if an employee causes damages and a lawsuit ensues, a member may be held personally liable if they negligently hired the employee in their own personal name as opposed to that of the LLC’s. This once again highlights the importance of conducting all business activities and contractual agreements in the name of the LLC.
Measures to Take for Maximum Protection
While an LLC is certainly one of the best vehicles to protect you from personal liability, it is clear that there are still limitations to the protection which it offers. As such, there are some useful measures to employ so as to maximise the protection that you get through the use of an LLC:
Make sure that you have both a good insurance policy covering your LLC’s liability, as well as additional umbrella insurance which covers you for personal liability claims arising during the course of business.
2. Separate finances completely
It is extremely important to keep all assets and finances of the LLC separate from your personal assets and financial affairs. The LLC must have its own business bank account and credit cards. All financial documents should have the LLC name on them, and should not be signed in your personal capacity.
3. Keep only what is needed in the company
If the LLC faces a lawsuit, whatever assets are owned by the LLC can be used to satisfy the legal obligations. For this reason, it is advised to not “overcollateralize” the LLC by keeping too much money in its name. Profits should be distributed to the owners where possible, and only what is needed for normal business operations and expansion should be kept in the LLC to avoid undue risk.
4. Consider additional asset protection strategies
LLCs are not the only financial vehicles that can successfully protect your assets in the case of lawsuits. It is worth exploring other strategies which can either be used instead of, or in conjunction with, an LLC, depending on your personal circumstances. Asset protection trusts are an example of a highly effective financial vehicle for protecting your personal assets, and maybe a better solution for many if that is their primary objective.
There is no doubt that an LLC is a powerful tool which can help to protect your personal assets when correctly structured and maintained. On the other hand, it is important to be aware of the limitations to this protection, and know that there are still situations where you may be held personally liable for the obligations of an LLC. Understanding these issues and how best to avoid these potential risks will help you maximise the protective benefits of an LLC.
The specific rules and exceptions which apply to LLCs will also vary greatly depending on the jurisdiction and state in which they are established. As such, it is always best to consult with a financial expert or asset protection attorney to help guide on the best way to form an LLC to protect your personal assets.