Although no business owner ever wants to consider the likelihood of being sued for unpaid business debts, breach of contract, or damages caused by their employees, business activities, or the like, these events do happen. What’s more, if businesses do not plan properly, owners may become personally liable for the debts of the business. This article discusses some ways to avoid personal liability in the unfortunate case that a business’s activities results in litigation.
The business attorneys at Gehres Law Library often recommend a three-pronged approach to aid clients in ensuring they are protected from personal liability for their company’s debts. The first step is to make sure that the business itself is structured as a business entity that protects and separates personal assets/liability from business assets/liability. The second step is to enter into agreements in a manner which will limit a business owner/officer/director’s personal liability. As a final step, obtaining appropriate insurance coverage, over and above what is required by law, that covers common business risks in the company’s specific industry, is also important in controlling personal liability exposure.
BUSINESS ENTITY CONSIDERATIONS
If you’re operating a business as a sole proprietorship, you and your business are, from a legal perspective, the same entity. That means that you personally, in addition to being entitled to the income of the business, are liable for all of your business debts. It also means that all, or most, of your personal assets can be attached, or considered for collection, by your creditors. Likewise, in a general partnership each partner is personally liable for 100% of the business’s debts. Therefore, if there aren’t enough business assets to pay the partnership’s debts, and your partner is broke, creditors can come after your personal assets to pay all of the business’s debts, not just your pro rata share of the debts.
On the other hand, if your business is formed as a corporation or LLC, you and your business are separate legal entities. As such, assuming that you do not otherwise expose yourself to personal liability, and your corporation or LLC is properly formed and maintained, you would have no personal liability for the debts of the business, even if the business can’t pay them. Our highly experienced San Diego Business Attorneys can assist you in determining not only the best type of entity structure for your specific needs, but also in preparing your corporate and other legal documents in a manner which provides you with maximum protection against personal liability for business obligations.
Maintaining corporate compliance once an entity is formed is also critical, such as preparing annual corporate minutes, ensuring the entity is adequately capitalized as required by the California Corporations Code, as well as addressing other compliance issues is also critical to ensure business owners are well protected. See our related articles on this topic here and here.
ENTERING INTO AGREEMENTS ON BEHALF OF YOUR BUSINESS
Once you have settled on the proper structure of your business ventures, it is important to also be cognizant of potential situations where your actions might undermine the protection you have tried to maintain by that formation against personal liability for the business’s debts.
One way that you may inadvertently waive your right to personal liability protection is to sign a personal guarantee for a business loan or line of credit. Any debt that you obtain using this method is yours personally should your business assets not be sufficient to satisfy the debt.
The next way that you might unknowingly expose your personal assets to attachment for business debts is by signing a contract or agreement in your personal name versus on behalf of the Company. For example, John Smith, who is President of ABC Corporation, would need to sign John Smith, President, on any documents related to the business/corporation when he is representing that business. If he simply signs John Smith, without including his capacity as an officer or agent of the Company, he may have just set himself up for personal liability for that debt. Seems harmless, but it could be an expensive mistake.
An additional way for a business owner/officer to subject themselves to personal liability is to use personally owned collateral or credit cards (not in the business’s name) to underwrite or accumulate debt on behalf of the Company. It is very important to remember not to comingle personal assets and debts with business debts.
Finally, along these same lines, if a business owner personally misrepresented or lied about any facts when applying for a loan or credit on behalf of the corporation or LLC, they could be held personally liable for the debt, as well as potential personal exposure for fraud, both civil and criminal. Also, as touched on previously, if a business fails to maintain a formal legal separation between the business’s and the owner/officer’s personal financial affairs, creditors will likely try to have a court hold those owners/officers personally responsible for the business’s debts under a theory known as “piercing the corporate veil.”
INSURANCE CONSIDERATIONS IN PROTECTING THE ASSETS OF THE BUSINESS AND THE OWNERS/OFFICERS
Over and above the necessity to ensure that a business entity is complying with both statute and contract by maintaining the required insurance coverage, such as workers compensation, vehicle coverage, general liability, including “acts and omissions” when appropriate, and property (real and business). An umbrella policy is often a good choice when underlying liability insurance may not be enough to cover a catastrophic loss or claim. This provides an added layer of protection for your company, and potentially the owners/officers if there is an attempt to obtain personal liability against them for the company’s debts.
Along those lines, obtaining a management liability policy could be invaluable for the following types of situations: 1. Directors and officers — basically this protects directors and officers, as well as the business entity, when there are allegations that their decisions resulted in the mismanagement of the company, causing a loss to others. 2. Employment practices liability —coverage that protects the directors, officers and the entity when there are allegations of discrimination, harassment and failure to promote and similar employment legal issues. 3. Fiduciary liability — If an officer or director acts in a role for example, the entity’s investment advisory board and there is a loss for the investors or employees, as in the case of a 401(k) plan, this type of insurance generally operates to protect the plan fiduciaries when there are allegations that they failed to fulfill their duties to the plan participants, assuming that there was no fraudulent intent or gross negligence.
In summary, taking steps to limit personal liability when starting and running a business provides peace of mind for a business owner and it is vital to consider at the beginning of the business cycle. Our San Diego Business Attorneys can discuss your concerns and options with you as well as assist you in setting up and maintaining your business entity in a manner designed to ensure the least amount of personal financial exposure possible in your circumstance. Contact us today for your complimentary consultation.