Business entities exist to protect your personal assets from your business liabilities, and vice versa. The most common business entities today are corporations and limited liability companies. If you are operating without a formal entity, your business is a sole proprietorship or, if there are multiple owners, a general partnership. In either case, without a legal entity in place, you are personally responsible for any liability that your business incurs. Your personal assets are at risk.
A business entity separates your personal assets and liabilities from those of your business. This works because the law considers business entities to be distinct legal persons. Your corporation or LLC is, in the eyes of the law, as distinct from you as your neighbor, hairdresser, or that guy selling heirloom radishes at your local farmers’ market. As a practical matter this means that if your business were to breach a contract, infringe intellectual property, or if an employee of yours caused a car crash, you wouldn’t have to worry about your own car, house, and vintage t-shirt collection being seized by the county sheriff and sold at auction to pay off the judgment.
The converse is also true. A judgment against you personally could lead to liquidation of your business. After all, you and your business are one and the same. If you are operating without a legal entity, all of your assets are at risk every day that you are in business. And as a general rule, the bigger your business, and the longer you’ve been operating, the greater your risk.
This liability protection is broad and favored by courts, but it is not unlimited. Although a business owner is not liable for the debt of the separate business entity, it has become common practice for banks to require business owners to personally guarantee any bank loan. If you sign a personal guarantee—and if you want a loan in this economy, you really have no choice—you will be personally liable for repaying the loan, even if it was made directly to your business entity.
An entity will also not shield you from liability for personal negligence, malpractice, or fraud. To take the familiar case of an employee who causes an auto accident on company time: the employer is probably liable for that accident, and the employee surely is, but the owners of the company, if it’s a separate entity, are not liable. However, if an owner had been driving and caused the accident, the owner would be liable, as would the company, even though the two are separate legal entities.
Similarly, if you use your position in the company to commit fraud, you will always be held personally liable, entity or not. Full stop.
Finally, there are narrow cases where courts will disregard the entity altogether and hold its owners personally responsible for certain obligations. This generally happens with single-owner corporations where the owner misuses the entity and treats it as a personal bank account. I will more-thoroughly address this topic in a future post.
So when it comes right down to it, you need a business entity because with every day and with every new project you undertake, your business is taking on greater risks. Sure, as a sole proprietor your risks may be small. But even a sole proprietor has risks to shield. And as your business grows in new directions, and brings on new clients, employees, owners, and outside capital, organizing yourself as a business entity becomes an absolute necessity. When your business is swinging for the fences, you will want an entity in place to give you the peace of mind that, while your business is taking on calculated risks, your personal assets are safe, sound, and protected.