LLCs and Limited Liability Protection

Like many business owners just starting out, you might find yourself in this quandary about liability issues: On one hand, having to cope with the risk of personal liability for business misfortunes scares you; on the other, you would rather not deal with the red tape of starting and operating a corporation. Fortunately for you and many other entrepreneurs, you can avoid these problems by taking advantage of a relatively new form of business called the limited liability company, commonly known as an LLC. LLCs combine the pass-through taxation of a sole proprietorship or partnership (taxes on business income are paid on each owner's individual income tax returns) with the same protection against personal liability that corporations offer.

Beware of special state rules. For example, California prohibits licensed professionals from organizing as an LLC (but not as a professional corporation or limited partnership). Some other states have extra LLC formalities for licensed professionals, which you can find out about by asking your state licensing board.

Limited Personal Liability

Generally speaking, owners of an LLC are not personally liable for the LLC's debts. (There are some exceptions to this rule.) This protects the owners from legal and financial liability in case their business fails, or loses a lawsuit, and can't pay its debts. In those situations, creditors can take all of the LLC's assets, but they generally can't get at the personal assets of the LLC's owners. Losing your business is no picnic, but it's a lot better to lose only what you put into the business than to say goodbye to everything you own.

Keep in mind that, like a general partner in a partnership, any member of a member-managed LLC can legally bind the entire LLC to a contract or business transaction. In other words, each member can act as an agent of the LLC. (Some LLCs are managed by managers, instead of by members. In manager-managed LLCs, any manager can bind the LLC to a business contract or deal.)

While LLC owners enjoy limited personal liability for many of their business debts, this protection is not absolute. There are several situations in which an LLC owner may become personally liable for business debts or claims. However, this drawback is not unique to LLCs—the limited liability protection given to LLC members is just as strong as (if not stronger than) that enjoyed by the corporate shareholders of small corporations.

Here are the main situations where LLC owners can still be held personally liable for debts:

• Personal guarantees. If you give a personal guarantee on a loan to the LLC, then you are personally liable for repaying that loan. Because personal guarantees are often required by banks and other lenders, this is a good reason to be a conservative borrower. Of course, if no personal guarantee is made, then only the LLC—not the members—is liable for the debt.

• Taxes. The IRS or the state tax agency may go after the personal assets of LLC owners for overdue federal and state business tax debts, particularly overdue payroll taxes. This is most likely to happen to members of small LLCs who have an active hand in managing the business, rather than to passive members.

• Negligent or intentional acts. An LLC owner who intentionally or even carelessly hurts someone will usually face personal liability. For example, if an LLC owner takes a client to lunch, has a few martinis, and injures the client in a car accident on the way home, the LLC owner can be held personally liable for the client's injuries.

• Breach of fiduciary duty. LLC owners have a legal duty to act in the best interest of their company and its members. This legal obligation is known as a "fiduciary duty," or is sometimes simply called a "duty of care." An LLC owner who violates this duty can be held personally liable for any damages that result from the owner's actions (or inactions). Fortunately for LLC owners, they normally will not be held personally responsible for any honest mistakes or acts of poor judgment they commit in doing their jobs. Most often, breach of duty is found only for serious indiscretions such as fraud or other illegal behavior.

• Blurring the boundaries between the LLC and its owners. When owners fail to respect the separate legal existence of their LLC, but instead treat it as an extension of their personal affairs, a court may ignore the existence of the LLC and rule that the owners are personally liable for business debts and liabilities. Generally, this is more likely to occur in one-member LLCs; in reality, it only happens in extreme cases. You can easily avoid it by opening a separate LLC checking account, getting a federal employer identification number, keeping separate accounting books for your LLC, and funding your LLC adequately enough to be able to meet foreseeable expenses.

Excerpted from The Small Business Start-Up Kit: A Step-by-Step Legal Guide, by Peri Pakroo (Nolo).