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What Does Limited Liability Mean?

Limited liability is an advantage of certain business structures. Through limited liability, investors are only liable for a company's obligations up to the amount they invested in the company. This means their personal assets have protection from the business's liabilities. With limited liability, your business creditors cannot go after your home, car, personal accounts, or other assets to cover your business's debts.

All businesses have a legal structure, but not all business owners have liability protection. A legal structure is sometimes called a business structure, or a form of business ownership. It is the type of business entity, or legal entity, you create.

A common legal structure is the sole proprietorship. If you own your business by yourself, pay your business taxes through your personal tax return, and have no business partners, you probably have a sole proprietorship. This legal structure does not offer limited liability protection. So, you can be open to unlimited liability for your company's debts as a sole proprietor. If your sole proprietorship becomes insolvent (bankrupt), then your home, personal accounts, or other personal assets could be at risk.

To protect your personal property from your business liabilities, you should create a limited liability legal structure such as a limited liability company (LLC), a limited liability partnership (LLP), or a corporation.

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Limited Liability in LLCs, LLPs, and Corporations

An LLC is a legal structure that has similarities to partnerships and corporations. Like a corporation, an LLC offers its owners limited liability protection. Like a partnership, it has a flexible structure. Many small businesses choose LLCs because they are simpler and easier to set up than corporations. But they still offer limited liability protection.

corporation is a more complex legal structure with extra layers of rules and regulations. Most small businesses are better suited by the simpler LLC structure. But you may need to think about incorporation if you want to issue stocks or have a large number of investors.

An LLP is a special type of partnership. It offers limited liability for all members, like an LLC. But this limitation can vary by state. Some state laws give limited liability to LLP partners for all business obligations. In other states, partners only receive limited liability for the other partners' negligence. The ease of adding and releasing members from an LLP is an added benefit. This makes it attractive to business owners in licensed industries.

LLPs are most commonly used in professions like accounting, architecture, medicine, and law. In fact, some states only allow LLPs for these types of licensed professions.

Choosing a Limited Liability Structure

Aside from liability protection, you might consider tax issues when choosing a legal structure for your business.

In partnerships, partners pay business taxes on the company's profits through their individual income tax returns. This is called “pass-through" taxation. Partnership taxes are sometimes preferable to corporate taxes. Corporations can be subject to so-called “double taxation." This is when the corporation pays taxes on its profits and stockholders pay taxes on their dividends too.

Members of an LLC may find the structure offers tax advantages. LLC taxation depends on whether you have a single-member or multi-member LLC. With a single-member LLC, the IRS will tax your LLC as a sole proprietorship. This means that you will pay taxes on your company's profits through your personal income tax return. For multi-member LLCs, LLC owners can decide whether they would prefer to pay taxes as a corporation or as a partnership.

How Do I Form a Limited Liability Legal Structure?

Once you have decided on a legal structure for your business, you should visit your secretary of state's website. There, you can find out how and where to file the official paperwork.

As an example, forming an LLC is a relatively easy task. You can usually complete the process online. You will need to fill out some forms, pay a modest filing fee, and submit your articles of organization. The articles of organization should contain basic information about your business. This includes:

  • Your business's address
  • The names of your LLC members
  • The nature of your business
  • Information about your registered agent

You should visit your secretary of state's website to find out more about the requirements in your state.

Keeping Limited Liability Status

One of the main reasons to create an LLC, corporation, or LLP is for the limited liability status. But if members of those types of businesses are not careful, they can risk losing this protection. If they lose this protection, then the business owners could be on the hook for the company's debtslawsuits, and other obligations.

You need to take certain precautions to protect your limited liability status. These measures help to make it clear that you treat your business as a separate entity. This way, it will continue to be legally distinct from you and any co-owners.

1. Separate your business and personal finances. If you mix your money with your business's funds, this is called commingling assets. An example of this would be if you use your business bank account to pay your personal bills. If you mix your finances with your business's, you could lose your limited liability protection.

To prevent this, you should use separate accounts for your business and personal needs. Further, you should use a business account or business credit card to pay for any business expenses.

2. Finance your business. You should make sure to put a reasonable investment into your business when you start it. Your initial funding might include your own money, loans, or investor funds. The initial investment should at least match your startup costs and operating costs for the first few months.

Remember that any money you put into your business can be at risk for your company's debts, lawsuits, and other obligations. Any equipment or real estate that your business owns can be seized to pay off business debts too. But it's still important to put enough money into your company so that it can operate as an independent entity.

Putting adequate funds into your company will help to avoid the impression that you underfunded your business. If you underfund your company and it becomes insolvent, you and your co-owners could be personally liable for the business's debts.

3. Follow corporate formalities. If you have a corporation, you need to take care to follow your state's rules and regulations closely. You will need to:

  • Hold annual board meetings and keep records of them. These records are often called “minutes."
  • Keep good financial records.
  • Follow your corporate bylaws.
  • Obey any other requirements your state may have for incorporated businesses.

If you have an LLC, you should make sure that you have an LLC operating agreement in place. This agreement forms a contract among you and your other LLC members. An LLC operating agreement is a key legal document, and you should have one even if you are a single-member LLC. This document adds legitimacy to your LLC and your limited liability status.

Most importantly, you should follow your state's rules for maintaining your LLC, LLP, or corporation. Disregarding these rules could lead to personal liability. Of course, you need to make sure that your business and its members do not engage in any fraud or illegal behavior either. This would pose a significant risk to you, your business, and your limited liability status.

How an Attorney Can Help

Starting a new business can be an exciting and busy time. But there will be legal issues to tackle as well. You might have questions about business structures, limited liability, licenses, taxes, and more. A local business attorney can help.

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