Are You Personally Liable If Your LLC Fails?

Forming an LLC comes with liability protection. This means that business owners can’t be held liable for debts, lawsuits, or other obligations incurred during operations.

Still, this protection isn’t absolute. Many LLC owners are shocked to discover that under certain circumstances, they can be held liable for any mistakes made by their business. Today, we discuss when personal liability applies to LLC owners.

Key Takeaways

• An LLC’s level of liability protection isn’t absolute. Certain actions can compel courts to hold LLC owners liable for the legal obligations of their business.
• Mixing personal and business finances, failing to follow corporate formalities, or undercapitalizing an LLC can get its corporate veil “pierced.”
• Licensed professionals with LLCs face personal liability for malpractice. Their entities can protect them from business debts or claims of another member’s negligence, though.
• Personal guarantees can reduce an LLC’s level of liability protection if they’re made to a lender, landlord, or vendor.
• To reduce your liability for an LLC’s legal obligations, consider:
  • Practicing proper record-keeping
  • Writing and implementing a comprehensive operating agreement
  • Purchasing a business insurance policy
  • Opening and maintaining a business bank account

LLCs & Liability Protection: An Overview

When an LLC is formed, it separates itself from its owners (or members). As a result, the latter’s liability for the LLC’s legal obligations is reduced.

Let’s say one member of your LLC owes debts to a creditor. The entity’s liability protection prevents the creditor from seizing the member’s personal assets to settle their debt. This benefit makes LLCs particularly attractive for small business owners and entrepreneurs who seek less exposure to legal liability while building their businesses.

Still, an LLC’s level of liability protection can be reduced. If an LLC operates as an “alter ego” of its owner, courts may “pierce” the entity’s corporate veil. The term describes the legal separation between the LLC and its owners.

Related Resource

Learn more about an LLC’s corporate veil from NCH’s 60 Second Business Tip series.

Compliance Update

Nevada’s LLC Act protects LLCs from potential liability, making the state attractive for entrepreneurs after maximum asset protection. The law recognizes that LLCs are separate from their owners, capable of owning property, entering contracts, and meeting their legal obligations.

When Can Courts Pierce an LLC’s Corporate Veil?

In some cases, courts may disregard an LLC’s existence and hold its owners personally liable for business obligations. They decide whether to do so after conducting a two-part test. Through this test, the court determines if an LLC has been used to commit wrongful behavior or avoid its obligations.

Here are some reasons why courts pierce an LLC’s corporate veil.

A Note on Personal Liability for Professional LLCs

While licensed professionals can operate as an LLC, they can be held liable for malpractice. Professional LLCs can only protect your personal assets from business debts and claims against other members of the entity.

When Do Personal Guarantees Reduce Liability Protection?

Personal guarantees can reduce an LLC’s liability protection if they’re made in any of the following situations:

Applying for a Business Loan

Some commercial lenders require personal guarantees from LLC members, especially for new businesses or those without substantial business credit. They make the individuals personally liable for the debt even if an LLC offers liability protection.

Personal guarantees stay in effect until the loan is fully repaid or until the lender ends the guarantee.

Entering Lease & Vendor Agreements

You may also be asked to make a personal guarantee to a landlord or vendor. In this case, the guarantee prevents you from avoiding obligations through dissolution or exits.

If your landlord or vendor needs a personal guarantee from you, review their terms before giving one. You can also limit your LLC’s legal liability by negotiating for better terms on leasing and partnership agreements.

Related Resource

Learn more about the mistakes that lead to piercing the corporate veil from NCH.

How to Reduce Personal Liability with an LLC

If you want to avoid personal liability for an LLC’s potential legal obligations, here are some effective strategies to implement.

• Practice proper record-keeping. Keep all financial records, meeting minutes (even for single member LLCs), documents related to major business decisions, and existing contracts and agreements on file.

• Draft and implement a comprehensive operating agreement. This document outlines how an LLC operates, what its members do, and how disputes within the business should be handled.

• Consider buying business insurance. Your options for business insurance policies include general liability insurance, errors and omissions insurance, and commercial property insurance.

• Open a business bank account. It’ll help keep your LLC’s funds separate from your personal finances.

What to Do When Your LLC Faces Financial Issues

When your LLC faces financial issues, your next steps can reduce or increase your liability for these challenges. Here’s how to handle and resolve financial issues without incurring any personal liability.

Avoid Fraudulent Transfers

During financial distress, payments to LLC members or other parties can be considered as fraudulent transfers. Courts can examine such transactions if your LLC gets sued. Specifically, they may look at personal payments made while business creditors remain unpaid.

Seek Expert Advice

Legal and financial experts can help you handle your LLC’s legal obligations with valuable advice and actionable strategies. You’ll need their expertise if your business gets sued.

Consider talking to lawyers or financial advisors before opening a new business. This way, your LLC’s decisions don’t reduce its liability protection.

Document Major Business Decisions

This last step becomes more important during periods of financial challenges. Ultimately, it shows authorities that your LLC acted in good faith to stay operational. Always keep copies of documents related to major business decisions on file and store them in a secure yet accessible location.

Frequently Asked Questions

Can I lose my personal assets if my LLC fails?

Yes, you can lose your personal assets if your LLC fails.

An LLC generally protects personal assets from its legal obligations by operating separately from its members. But if courts determine that the LLC is run as your alter ego or used to avoid personal obligations, they can pierce its corporate veil.

How can LLCs lose their liability protection?

LLCs can lose their liability protection by:

• Commingling personal and business funds
• Failing to follow corporate formalities
• Taking on significant obligations with minimal capital
• Making personal guarantees to creditors

Courts decide whether to pierce an LLC’s corporate veil based on any of these factors.

Does my LLC need business insurance?

Your LLC needs business insurance if it operates in a high-risk industry. The protection provided by this type of insurance works together with an LLC’s limited liability protection.

Specifically, business insurance covers the costs of your LLC’s legal liabilities. These may include litigation fees and damages that should be paid to the plaintiff.

Can personal creditors pursue my LLC’s assets?

Since an LLC separates itself from its owner, it prevents personal creditors from pursuing business assets.

A creditor can request a charging order to force an LLC member to pay any owed debts. However, this only gives the indebted person’s financial rights to the creditor. The creditor isn’t allowed to interfere with an LLC’s management.

How do I know if my LLC is at risk of losing its liability protection?

Your LLC may lose its liability protection if you:

• Mix personal finances with business funds.
• Fail to follow corporate formalities.
• Use it as your alter ego or to commit fraud or wrongdoing.

What happens to personal guarantees when an LLC dissolves?

Personal guarantees continue even if your LLC dissolves. In short, you still need to fulfill these obligations after deciding to close your business.

If you’re dissolving an LLC, ask creditors to file claims before starting the process. Take some time to settle any outstanding debts, so your business can close without problems.

Can an LLC owner be held liable for unpaid taxes?

Yes, an LLC owner can be held liable for unpaid taxes.

Liability protection doesn’t cover taxes owed by LLCs. If these taxes remain unpaid, the IRS or state tax authorities can hold an LLC owner liable for them. Hence, you must file unpaid or underpaid taxes to avoid legal issues.

Does undercapitalizing an LLC affect liability protection?

Yes, undercapitalizing an LLC can affect liability protection.

If the business lacks sufficient funds to operate or meet foreseeable obligations, courts may disregard its existence. This can support claims that the LLC is merely a “shell” entity, allowing courts to pierce its corporate veil.

Can fraud or misrepresentation reduce an LLC’s liability protection?

Yes, fraud or misrepresentation can reduce an LLC’s liability protection. If you use the entity to commit these activities, you may be held liable for it. However, LLCs can protect you and your personal assets from claims of another member’s wrongful conduct.

Can I lose my personal assets if I violated the terms of my LLC’s operating agreement?

Yes, you can lose your personal assets if you violated the terms of your LLC’s operating agreement. This may indicate poor governance, increasing the likelihood of a court disregarding the LLC’s existence.

Expert Tips From NCH

1. Open and maintain business and personal bank accounts. Never use business funds for personal expenses and always deposit business income into your LLC’s business bank account.
2. Keep detailed records of all major business decisions. Document them in writing, even if you run a single-member LLC.
3. Review and update your LLC’s operating agreement when needed. It should be revised as your operations expand and adhere to current or amended state laws.
4. If your LLC faces significant financial challenges, talk to an attorney or financial advisor. Their expertise will help you maintain your LLC’s liability protection during these challenging periods.
5. Conduct compliance audits with professional assistance. Schedule them regularly to ensure that your LLC stays compliant with its home state’s legal requirements.

Form & Operate a Legally Compliant LLC Today

Although LLCs protect you and your personal assets from their legal obligations, it isn’t permanent. You must keep an LLC separate from yourself by operating the business in good faith and staying compliant with your jurisdiction’s legal requirements. Overall, it helps you reduce personal liability and ensure effective asset protection.

Want to learn how to keep your LLC in good standing and shield personal assets from creditors? NCH’s legal and business formation experts are ready to discuss these matters with you.

Talk to Our Experts Today

DISCLAIMER: The above material has been prepared for informational purposes only, containing opinions of the provider and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. Please consider consulting tax, legal, and accounting advisors before engaging in any transaction.