Sole Proprietor or LLC?
By Joseph Kang
The most important feature of becoming a limited liability company (LLC) is having limited liability in your business. The definition of liability is the state of being responsible for debts or other financial obligations. LLCs provide its members with protection from creditors by making their businesses a separate entity from the individual owner(s). Why is it important to not be liable for one’s business? It is so that you, the business owner, are not responsible for the debts and lawsuits of your company. A member of an LLC has a safeguard from creditors and lawsuits to shield his or her personal assets. While you may be confident that you are operating your business legally, a lawsuit or an audit may reveal serious cracks in your business’s foundation. You don’t want to be in a position where you created a mess and must now clean it up. Work with your lawyer to form and run your business properly. Get regular business audits too.
By registering your business as a limited liability company, you can form a legal barrier between you and your company. For example, if your business fails and becomes insolvent, (with some exceptions) you should not be responsible for the liabilities of your business. After the complete liquidation of a company’s assets and after its proceeds are given to the creditors, the creditors cannot collect the remaining debt from the individual members of the company if you are shielded. This protection keeps your personal assets secure, and your personal assets will be considered unrelated to your business.
If you are a sole proprietor, then the business becomes an extension of yourself. Whatever harm comes to the business can also harm you. When lawsuits and claims are made against your business, there will not be a legal boundary between you and the business. And if the assets of your company are in jeopardy, then your personal assets will be as well.
Unfortunately, limited liability protection is fallible. When business owners do not clearly separate business transactions from personal transactions or when a business is run fraudulently or when the business owner was grossly negligent, for example, courts may decide to “pierce the corporate veil.” This means that the legal barrier that was once separating you from your business is now gone.
Courts have also pierced the corporate veil in parent-subsidiary structures. For example, some businesses form subsidiary businesses under the auspices of a parent company. The parent company and the subsidiaries are legally separate entities. However, there are two specific scenarios where a parent company could be liable for its subsidiaries.
Under the Alter Ego Theory, if a parent company’s control and domination of the subsidiary company is so extensive that the legal identity of that subsidiary does not exist, courts may decide that the subsidiary company is one and the same as the parent company. In other words, the subsidiary company is essentially conducting the parent company’s business, and thus, the courts will decide that the parent company’s assets are no longer shielded from the subsidiary’s creditors.
Under the Agency Theory, a subsidiary is acting as the parent company’s agent. This means that the subsidiary has the authority to speak and act on behalf of the parent company. If courts decide that the subsidiary company is an agent to the parent company, then the parent company may be responsible for the actions taken by the subsidiary since it is acting in lieu of the parent company. When specific evidence is shown to prove either the Alter Ego theory or the Agency theory, a court proceeding may find that there is no legal separation between the two entities, and it may pierce the corporate veil.
Forming an LLC or other business entity for your business is a responsible first step for every new business. While there are limits to limited liability, your personal assets will be protected so long as you maintain your limited liability protection with careful recordkeeping. After all, starting and maintaining a new business is hard work, and you want to protect what you’ve earned.
Joseph Kang is a student at Purdue University. He will graduate in May 2019 with a B.S. in Pharmaceutical Sciences. His college career consisted of being involved with his fraternity and campus organizations such as Purdue Dance Marathon for Riley’s Children’s Hospital and College Mentors for Kids. Joseph has experience working in a medical clinic—helping patients and clinicians as a medical assistant. Joseph plans to pursue law school after graduation. While interning with Kimberly Shin Law Firm PLLC, Joseph researched and wrote articles to help small business owners and entrepreneurs with legal challenges their businesses may face.
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