Many business owners operate under an entity such as an LLC, C Corporation or S Corporation, yet 73% of all businesses in the U.S. operate as sole proprietors.1 While sole proprietorships are easy and inexpensive to form and maintain, the owner is subject to all the business's losses. This means business bankruptcy impacts an owner's personal finances; essentially their personal liability in a sole proprietorship is unlimited.
Limited liability entities (by definition) exist to limit one's personal liability to their businesses. In an LLC or Corporation, for example, losses are limited to your financial contribution to the entity (plus any retained earnings).
It's important to note, however, that even if you own an LLC or Corporation, it's possible to experience personal liability if there is a "piercing of the corporate veil". Courts may consider piercing the corporate veil when creditors suffer an unjust cost, when the company acts fraudulently, and when owners commingle personal assets with corporate assets and fail to follow corporate formalities, such as:
- Holding annual meetings of the board of directors, members or shareholders
- Keeping detailed records of important decisions from meetings
- Adopting company bylaws
- Making sure company officers and agents are abiding by those laws2
The COVID-19 shelter-in-place mandate has crippled many small businesses. This time serves as a good reminder of the value of limited liability. While in most cases small businesses owners must personally guarantee loans, loan programs under the CARES Act including the Economic Injury Disaster Loan and Paycheck Protection Program loans have allowed small business owners to obtain much needed capital without a personal guarantee.
The question most business owners are asking today is, "What if the loans are not enough?". Although it's often a temptation to funnel personal savings into a business to keep it afloat, owners must seriously consider the implications of doing so. As owners commit more personal assets to their companies, they are increasing their liability or risk of losing those assets.
Short term financing can make sense if there is a high likelihood of a return to profitability (and especially when there is no personal guarantee)! However, it's as important to take advantage of any flexibility you have to make your overheads more affordable, including:
- Negotiating with suppliers, vendors and clients
- Contacting your landlord or mortgage holder about payment deferrals
- Contacting your credit card companies about payment deferrals, interest rate grace period and/or interest rate reductions
- Contact your existing lenders about payment deferrals
- Modifying staff hours (though reductions could adversely impact PPP Loan forgiveness during the 8 week covered period - see our blog on PPP loan forgiveness here)
If debt is continuing to pile up and creditors won't negotiate terms, restructuring might make sense. The Small Business Restructuring Act of 2019 created Subchapter 5 under the Chapter 11 bankruptcy rules allowing businesses with less than $2.73 million in debt (temporarily expanded under the CARES Act to $7.5 million) the power of reorganization while continuing to run their businesses.3 This would allow filers to stop collections and renegotiate terms.
There are risks aside from the current pandemic that can put stress on businesses including personal injury, property damage and professional errors. These are risks which can be mitigated with appropriate insurance coverage, such as general liability insurance, commercial property insurance and professional liability insurance to name a few. You can further reduce risk by also purchasing a commercial umbrella insurance policy, which adds additional coverage that drops down over existing policy liability limits.
On the personal side, married couples can limit personal liability by titling assets as tenants in the entirety. This titling creates an indivisible ownership in the asset and prevents attachment to a lawsuit from one spouse's creditors. However, if both spouses are being pursued by joint creditors, or if there is a divorce or death of one spouse, this protection likely won't be very effective. Personal umbrella insurance can help provide additional liability protection above and beyond basic auto and homeowners limits. An LLC or a Domestic Asset Protection Trust can also be considered to protect personal property; these are often used in situations where malpractice is a concern or when minimizing estate tax is also an objective.
In short, business owners can limit their liability by:
- Forming an appropriate entity for their business,
- Ensuring the entity continues to operate in good standing,
- Attempting negotiations with existing creditors to maintain solvency,
- Avoiding capitalizing the business with personal assets,
- Obtaining the appropriate lines of business insurance,
- Titling jointly held personal assets as tenants in the entirety (only available to spouses),
- Obtaining personal umbrella insurance, and
- Creating an LLC or Domestic Asset Protection Trust to hold personal property