As a business owner, you face two perils that your employees do not face. First, you run the risk of having your personal assets seized to pay off your business creditors, whether the threat comes in the form of vendors demanding payment or lawsuits arising from your business. And, conversely, you also run the risk of having your business destroyed by a personal creditor who seized upon your business to pay off your personal debt.
To fully protect both your business and personal assets, you need to implement a comprehensive asset protection plan that includes purchasing insurance, using limited liability protections from formal business entity formation, and actively managing your finances to avoid exposure. Think of them as the three legs of the stool that is your asset protection plan.
Why should I worry about asset protection? I have insurance.
While insurance does provide a measure of security—and is essential for some occupations and activities—it cannot shield your assets from all threats. Insurance policies are limited in what risks they cover and how much they pay. Either of these limitations can spell disaster to the small business owner. More importantly, insurance can’t adequately protect you from economic downturns and inability to make payments to creditors.
Insurance can’t cover every risk. Even though you can buy insurance that will pay off if you are abducted by aliens, most insurance doesn’t protect you against far more probable events. The classic "uninsurable risk" is “punitive damages,” which go beyond merely compensating the person who sues you and "punish" you for conduct that was more than simply negligent. Although punitive damages aren’t the norm, even well-intentioned business owners can be at risk.
- Example: Sally Slippery falls on a patch of black ice in your restaurant’s parking lot. At trial, Sally’s attorney demonstrates that the ice was from an improperly located drain pipe and that seven people had already been injured by falling in that very location. Sally is awarded $300,000 for compensatory damages and $500,000 in punitive damages.
Plus, most policies have numerous exclusions from coverage. In one case, a company was stunned to discover that its “business interruption insurance,” would not pay because the fire that rendered the office inaccessible occurred in the building next door. In addition, the amount that your policy will pay is limited.
- Example: Chris Customer slips and falls while shopping in your store. Chris is awarded $1.5 million in damages. Your insurance coverage is limited to $1 million. The $500,000 which is not covered by insurance becomes a lien on your assets. If you are operating your business as a sole proprietorship or a partnership, you can lose everything—all of your business assets and all your personal assets. Plus, that judgment can hang over your head for decades, siphoning away your wealth as you attempt to accumulate it.
Insurance can’t protect against economic hard times. Insurance is designed to compensate, or insulate, you from loss from an "occurrence," such as a fire or a lawsuit. Insurance is not designed to protect you in the event your business falls on shaky times and you are unable to meet your bills. If you are unable to pay a supplier, that supplier can get a judgment against you for breach of contract. If you are a sole proprietor, the creditor can levy against your personal property, as well as your business assets.
Formal business entities provide additional liability coverage
So, clearly, in order to fully protect your business and personal assets, you need more than insurance. You need to take steps to place assets beyond the reach of your creditors. One of the most important steps to take is to conduct your business in a manner that separates business assets from your personal assets.
You have a variety of options when it comes to structuring your business: sole proprietorship, partnership, C corporation, S corporation and limited liability company (LLC). From the viewpoint of protecting what you have, operating your business as a sole proprietorship is a mistake. While this form of business is the easiest to start and run, all of your assets—personal and business—are within reach of any of your creditors—personal or business. Operating as a partnership does little to protect your assets. As someone who runs the business, you are probably going to be a general partner which affords only slightly more protection than operating as a sole proprietorship.
Choosing the structure. The best way to protect your personal assets from the reach of business creditors is to operate your business as an LLC or as a corporation. While both can be effective to shield your personal assets from business creditors, the LLC has some advantages in terms of simplicity and flexibility. Of course, the best structure for your business turns on many complex and personal factors, so your best bet is to use this information as a starting point for a conversation with a business advisor, such as an attorney or accountant.
If you are operating your business as an LLC or corporation, then your liability for the business's debts is limited to the assets of the business—and only those assets. Moreover, depending upon the state of company formation (and you choose the state of formation—it does not have to be where your business is located), your creditors may be prevented from reaching your ownership interest in your LLC, where they could gain control of corporate stock.
Avoid undoing your careful planning. While forming as an LLC or a corporation generally protects your personal assets from business creditors, it’s easy to trip up and cost yourself this protection. Of course, fraud will nearly always expose you to personal liability, but purely innocent actions can have the same impact. How? A common mistake is to personally guarantee a business debt or obligation. A creditor can go after any co-signer. As a result, your personal bank account could be tapped to pay a business debt. Another common mistake: acting as if the separate entity wasn’t separate by mixing business and personal expenses, payments and assets together. You must keep a wall between your business and personal life, if you want business creditors to do so.
Actively managing finances to preserve your wealth
Once you have a structure in place that protects your personal assets from your business creditors, you’ve made significant progress, but you may want to consider an additional layer of protection for your business. Why? Because, it is the owners who enjoy limited liability from business creditors: the business can lose everything it owns. In order to protect as much of your wealth as possible, it’s best to have as little invested and maintained in the business as possible. You can manage this by strategic funding and structuring and by careful planning of day-to-day operations.
Holding companies and operating companies. One of the tried and true ways to thwart creditors is to structure your business using two entities: a holding entity and an operating entity. As the names imply, the "holding entity" holds the title to the business assets, leasing or loaning them to the "operating company," which conducts the day-to-day business. Yes, all this does sound complicated. However, if you have a highly successful business or a business that has significant exposure to lawsuits, such as a restaurant or construction company, the initial aggravation and cost will reward you with substantial peace of mind over the long run.
No one of these asset protection strategies is enough to protect you and your business, should something go wrong. But combined together, these strategies can offer almost impenetrable protection to the business owner who legally operates a business—and who makes these preparations in advance.