— July 11, 2019
Asset protection means preserving your hard-earned wealth from being taken by others in legal actions, justifiably or otherwise.
America is a wildly litigious society. We have just 5 percent of the world’s population, but we generate 95 percent of the world’s lawsuits. No kidding, 95 percent. You don’t have to be at fault to be sued. You don’t even have to own the asset that injured the other party. You just have to have deep pockets.
Put simply, if you have money, you will automatically attract lawsuits.
Business Risk Plus Personal Risk
As an entrepreneur, you face much more risk of lawsuits than the average person does, and you sit under a truly double-edged sword. You are at risk because you are wealthier than average, but you are also at risk because you have an ownership interest in a business.
Even if you own a simple ice-cream stand, a customer could sue you. An employee could sue you. A partner could sue you. Your suppliers might choose to sue you. Indeed, anyone remotely associated with your business could find a reason to take you for everything you have.
Do not think that just because you are not at fault, you are safe. Jurors are usually more sympathetic to anyone who has suffered a misfortune than to businesspeople or wealthy people. “Surely,” think jurors, “someone should pay.”
The purpose of asset protection is to isolate you personally from the liability generated from both your business and your daily life.
Protecting Against Business-Associated Risk
Let’s start with protecting personal assets from the risks associated with your business. How do you keep your own funds safe when your company gets sued, goes bankrupt, or otherwise faces liability? As with tax mitigation, you must begin by choosing the right legal structure for your business.
Sole Proprietors, Partners, and Limited Partners
If you choose to do business under your name as a sole proprietor, you have no personal protection whatsoever from lawsuits generated by your business dealings. If someone goes after your business, all your personal assets are under threat.
If you set up a simple partnership, you also have no protection. Indeed, the risk is even higher because every partner is personally responsible for everything that happens in the business no matter who takes the action. If you have one partner, you are responsible for his or her actions as well as your own. If you have one hundred partners, you are liable for the actions of all one hundred.
In a limited liability partnership, or LLP, the types of partners are differentiated by risk. You may function as a general partner or a limited partner. General partners run the business, but limited partners merely provide capital. Let’s say I enter a partnership with you to create a fleet of ice-cream carts. You know how to make great ice cream and deploy carts, so you become the general partner. I merely put up a $ 100,000 investment, register as a limited or “silent” partner, and take absolutely no part in running the company. If one of your carts mows down a pedestrian, you may be personally sued if you have not created a more protective legal entity, but my liability is limited to the $ 100,000 of capital I put into the company. It may be possible to remain a limited partner even if I work in the business, as long as I fully stay out of managerial roles.
Still, the risk for all parties remains high.
The bottom line? In most cases, at least in terms of risk, it’s a terrible idea to run a business as a sole proprietorship, a simple partnership, or an LLP.
Corporations Versus Limited Liability Companies
If you really want to protect your personal assets from business risk, you must establish either a corporation or a limited liability company, known as an LLC. Remember, however, that from the perspective of risk, the difference is profound, and your bias should be toward the LLC structure if at all practical.
The Trouble with “Corporate Veils”
No doubt you have heard of establishing a corporation to “create a corporate veil” between you and your business. Unfortunately, the term “veil” often proves all too descriptive. If woven improperly or not maintained diligently, your own corporate veil will be no more substantial than the old-fashioned lace variety and will be easily “pierced” by an opposing attorney trying to get at your personal wealth.
Indeed, it has become common for a plaintiff to successfully sue a corporation and its directors personally at the same time.
S and C Corps Identical from the Risk Perspective
In such cases, it doesn’t matter if we are talking about an S corp or a C corp, because the liability issues are nearly identical. The differences between S and C matter a great deal in taxation but hardly at all in personal risk.
Don’t make the common mistake of thinking that the more formal C corp provides the maximum separation between you and your business’s liability.
The problem with a C or S corp is that it requires an extremely high burden of record-keeping and corporate formalities, which may be impossible for a smaller entity to maintain. This includes a formal board, board meetings, corporate minutes, regular filings, and much more. Fail to keep the formalities, and an opposing attorney will claim that your corporation doesn’t actually exist and that you are personally liable for everything that occurs. Even the smallest lapse may prove your undoing.
How the Veil Gets Pierced
How do plaintiff’s attorneys attempt to “pierce the corporate veil” and go after your personal bank accounts, insurance policies, and even your house?
First, they look for evidence that the entrepreneur is using business money to pay for personal expenses. If you’ve been good with separating these monies, the attorney will next subpoena your corporate minutes to see if you have been holding quarterly meetings and so forth. If you don’t have proper documentation, you can find your personal assets fully exposed.
To summarize, the veil provided by a corporation can be “pierced” by an opposing attorney if the following occur:
- You mix personal and business assets.
- You don’t properly capitalize your company.
- You don’t hold your quarterly and annual board meetings and keep detailed, accurate records.
- You don’t do the formalities, such as creating company bylaws.
- Your officers don’t abide by those bylaws.
The above list is not exhaustive, but such mistakes are the most common. Knowing how to recognize these mistakes is the first step to avoiding them and protecting your assets.
This article is adapted from the book Entrepreneur Wealth Management Made Easy: Building Wealth Beyond Business and Life Beyond Work.