Incorporate for Liability Protection

To incorporate a business means that the business owners are protected by state and federal law that shield your personal assets from business obligations. When you are incorporated, you may have to consider protecting your business from the unforeseen. Here we will discuss different levels of liability protection for incorporated businesses.

Without being incorporated, the business owner is 100% on the hook for business obligations, debts, contractual liability and any events associated with business activity. Once you incorporate, you separate the business from personal affairs and you have a degree of protection. Let's compare the liability protection between Corporations and LLC's and identify additional measures of protecting your business.

Business Liability Protection: Corporation vs. Limited Liability Company
When it comes down to protecting the business owner's personal assets from business obligations, the Corporation and LLC offer equal protection through state law. One primary differentiation is that LLC's lack the long standing history of holding up in court. Corporations have a proven track record of hundreds of years. Any properly organized, operated and maintained incorporated business structure will shield the business owner from obligations related to business activity. It's important to adhere to mandatory operating formalities and keep formal separation between business and personal affairs. After that, there are additional measures you can take in order to increase the protection offered, after you have incorporated your business.

EXAMPLE:
John owns a flower shop that sells exotic, hard to find and specialty flowers to his community. His business also delivers locally and takes large orders for special events. After a slow year, John had hit his credit limits with his vendors. Bringing in plants and flowers from all over the world, lead to a thousand dollars here and a few thousand dollars there for his floral pipeline. Vehicle payments and store rental lease make up another portion of his business obligations. John was faced with filing Bankruptcy and wound up his business. His total business debt to creditors, vendors and landlord totaled $50,000. Now for the sake of this example, all we will state is that John formally organized his business into an incorporated structure and operated it properly. John's personal assets, his home, vehicles, bank accounts and any investments cannot be used to satisfy what the business owes. In this case, it wouldn't matter if John was a standard Corporation, S Corporation or an LLC. The fact that John had the business organized and incorporated is where the liability protection stems from. A Corporation or LLC would not have any more or less protection in this case.

Personal Liability Protection: Corporation vs. Limited Liability Company
Lets take another look at comparing the two entities from a different angle. In this case, we'll assume that you, the business owner is sued personally. Lets examine the assets that are at risk in a judgement; real property owned, bank accounts, investments, vehicles and corporate stock. Yes, the shares of stock you own in a corporation are assets that can be used to satisfy a judgement. Interest in an LLC, on the other hand, is not considered property that can be awarded in the event of a judgement. Now there is something called a charging order where a court can award a judgement on the profits of an LLC to another party. This is complicated, however possible. This means that the awarded party is entitled to the profits of the LLC, but wait, here's the catch - the party only receives what is actually distributed. Wait, it gets worse, the awarded party would be held liable to pay taxes on the amount of the profit in the LLC, whether or not any or all of the profit was distributed. Which would make that judgement a liability, rather than an asset. The LLC can provide a higher degree of protection of assets from a personal suit. Corporate stock is considered property, anything the corporation owns is included.

Personal Exposure Exceptions
Even if you incorporate your business and operate according to state and federal formalities, you can still run into a situation where you expose yourself to business obligations. Specifically if you sign a personal guarantee for anything, a loan, line of credit, merchant account, etc. Anytime you enter a binding contract that you guarantee personally, your business structure no longer protects you, personally, in the event the business cannot satisfy the terms of the agreement. Another example is paying taxes, which we should all know. The IRS will pursue the responsible party in the event that taxes are not paid, business or otherwise.

Owner and Manager Agreements
Another critical element that relates to the organization of your business after you incorporate, is well documented agreements and bylaws. This is where you state how the company is managed and allocate powers to managers. For example, an LLC run by two managers may have a clause in the operating agreement that states that no one manager can obligate the business to more than $10,000 without unanimous consent of the managers. If any contract is executed in excess of an amount allowed within internal company documentation, that is an unlawful transaction, where the signature authority of the agreement can be held liable for the obligations and not the business. This can lead to a complex situation, however you can still limit the liability with partner and employee actions through detailed agreements and bylaws.

Another control that can be put into place is how much debt, or compensation for business expenses any individual or held position in the company can incur. If your operating agreement or corporate bylaws dictate how much a company check can be written for with just one signature, you can limit your exposure to poor management decisions. If an owner or manager of a company can only sign a check for an amount less than $10,000 without two signatures, you can further protect the business. These types of activities should all be accounted for in the internal documentation of the business, such as operating agreements and corporate bylaws.

The Unforeseen
So you incorporate, organize properly with great detail to your internal documentation. What happens when disaster strikes? A fire, flood, or criminal act? This is where insurance comes into play. Without it, you make be faced with a loss of inventory that could put a small business under. Perhaps an event that would force a business to keep its doors closed for several months, which could easily close the doors on a small business.

Insurance can be a great tool to help limit liability in other areas. There are tons of them, product liability, theft, fire and flood. Employees and workplaces expose the business to huge liability that should be addressed. Seeking a positive solution to this that works with your needs and amount of liability could mean simply having adequate insurance.