Week 2: But really, why should I form an entity?

I don't mean to be boring here, but I do mean to belabor the point: 

A business entity protects your personal assets from the liabilities of your business. The most important reason small business owners should consider forming a business entity is to protect their personal assets, in the event their business gets sued or financially goes under.  Generally, as long as you follow some basic rules and don’t use the LLC to break the law, forming an LLC means that you likely will only be on the hook for the amount of money or property you put into the business.

Let’s say there are 2 people John and Mary who each operate their own business. John is a “sole proprietor”.  As sole proprietor, John operates his business under his own name. He does not have to make any legal filings, or do anything special. He reports his business income and losses on his personal income taxes. He has no liability protection.

Mary, on the other hand, operates her business under Mary, LLC. She filed her Articles of Organization (more on this later) with the Secretary of State, and makes an annual filing to maintain her status. She has entered into an Operating Agreement with the company (more on this later). She has a business bank account and a taxpayer ID number that she got from the IRS that is different than her social security number. She does not mix her personal and business money. She also reports her business income and losses on a schedule to her personal income taxes.

Both John and Mary have children and are saving for their college expenses. They have retirement accounts, and savings accounts. They each own a home and a car.

Now let’s say that both John and Mary get sued (independently of each other) and are each found to owe the person suing them $50,000.  John has no liability protection. This means that he would be required to use his personal assets (college fund, savings accounts, proceeds from selling the car, et cetera) to pay the $50,000 judgment.  Mary on the other hand, if she has properly maintained her LLC (more on this later), would likely (assuming there’s no personal liability involved) only be liable to the extent of her capital contribution and business assets (what she’s put into the business). Meaning she might have to sell everything her business owns, but she would not have to dip into her personal assets, selling her house and car and liquidating her kid’s college fund to satisfy the judgement.

The same facts would also apply to a situation where John and Mary got in over their heads and owed business creditors money. Now most lenders require business borrowers to sign a “personal guaranty” meaning that the borrowers agree that if the business cannot repay the loan, they will dip into their personal assets to pay it off. However, where no personal guaranty was required, a business operating through a properly formed limited liability entity would only be on the hook for the amount of money/assets held by the business.

In a nutshell, this is the biggest reason that having the protection of a limited liability entity is important. To me, the question isn’t how big your business is, but whether you have personal assets that you wouldn’t want to have to liquidate in the event of a lawsuit. Feel free to reach out to talk more (and as always, until you hire me via a signed engagement letter, you are not my client. This blog is educational in nature and not intended to be legal advice).