THE BLOG

What Small Business Owners Should Understand About Liability

04/29/2015 09:55 am ET | Updated Jun 29, 2015

If you own a small business, you may have thought about liability issues... or maybe not. In some industries, the liability risk is obvious. For example if you run a tattoo parlor, catering business or in-home daycare center, you probably have thought about your risks and liability.

But if you're a freelance writer, consultant or graphic designer, you probably haven't considered that sitting behind a computer for work could put you in a danger of a lawsuit.

Most likely, nothing bad will ever happen with your business. You'll never be sued or run into debt. However, as a business owner, you want to protect yourself from worst-case scenarios. And fortunately, it's not too difficult once you understand the basics about business risk and personal liability.

Business structure is key to separating personal and business liability

A small business can be structured in numerous ways. If you never created a formal business structure, then by default you have a sole proprietorship (one owner) or general partnership (multiple owners). These business structures are the simplest to form and manage, but there is one key drawback: there is no separation between the business owner and the business.

If you own a sole proprietorship and your business is sued by a customer or vendor, then this is the same as being sued personally. All of your personal assets, savings, and property might be at risk in the court's judgment.

Now when my husband and I launched our first business out of law school, we didn't have many assets to worry about. Maybe you think your bank account isn't big enough to think about protecting right now. However, you should know that creditor judgments in the U.S. can last up to 22 years. Should your business be sued today, your personal assets may be vulnerable for up to 22 years.

You may not have realized that starting a business, even a side business that brings in just a few thousand dollars per year, could put your personal assets at risk. Fortunately, there's an easy solution for separating your personal and business assets: creating a formal business structure like an LLC (Limited Liability Company) or corporation for the business.

Once you create an LLC or corporation, your business now exists as its own entity and is responsible for any of its debts and liabilities. There's a corporate shield (also called a corporate veil) between you and the business, and this helps protect your personal assets in many circumstances.

Personal liability and business

While formal business structures like an LLC are an important first step toward safeguarding your personal assets, there's a common misconception that incorporating will automatically protect you from all personal liability. However, there are still several situations where you can be personally liable. For example...

1. Whenever you personally guarantee a loan for your business, you will be personally responsible for that debt. Likewise, when you sign a business contract as an individual rather than in the name of the business, you will be held personally responsible for meeting the terms of that contract.

2. A corporation or LLC also won't protect you if you commit a crime while running the business.

3. If your actions injure someone, you can still be personally liable. This is because an LLC or corporation can protect you from personal liability for contractual lawsuits, but not against tort lawsuits. This is the reason that most professionals (doctors, drivers, etc.) take out a good professional liability insurance policy.

4. Lastly, if you fail to keep your corporation or LLC in good standing, then a plaintiff may try to go after your personal assets. The most common ways that a company falls out of good standing are failing to keep a sharp distinction between business and personal finances, and not keeping up with the annual filings and fees to the state.

None of this is meant to scare any budding entrepreneur from starting a business. There's a very, very small chance that your business will ever be sued or can't pay back its debt. Yet while the risk may be slim, any business owner still needs to take liability matters seriously. A few proactive steps, like incorporating or forming an LLC, can help you avoid any pitfalls down the road, no matter how big or small your business may be.