© 2002 Elena Fawkner
Running a business involves risk - risk that business may either succeed brilliantly or fail miserably. Or neither. The upside is high -- financial and (perhaps) time freedom; independence; unlimited earning capacity. The downside is equally steep, just in wrong direction -- potential financial ruin if you've staked everything you own on your business's ultimate success and thrown your career down proverbial to boot. If you're running your business as a sole proprietorship or a general partnership, make no mistake -- everything you own is on line.
There's a lot that can go right and wrong in a business. A lot of it out of your control. But extent of your personal financial liability for what goes wrong is one thing you can and should control.
The answer is to form an entity separate from yourself to run business.
WHICH BUSINESS ENTITY?
As you probably already know, you have several choices when it comes to your business entity. The most basic is a sole proprietorship, followed by a partnership (general or limited), a limited liability company ("LLC") and a corporation (either a general "C" corporation or an "S" corporation - more about these later).
Although sole proprietorships and general partnerships are relatively straightforward and inexpensive business entities to establish and maintain, hence their popularity, neither of them protects you from personal liability.
If you're a sole proprietor, you've probably made this election by default - by doing nothing other than starting a part-time Internet business out of your spare bedroom, most likely.
A limited partnership will protect limited partners from personal liability beyond extent of their capital contribution to partnership, but limited partners cannot participate in management and control of business so that's not a good option for most of you reading this article. Needing to control and manage your own business is most likely non-negotiable.
As an attorney, I generally recommend that small business owners, including (especially!) home-based and Internet entrepreneurs, incorporate at least as soon as they are generating sufficient profits from business that amount of tax payable on such profits equals or exceeds minimum franchise tax payable in state in which business is being conducted. In California, for example, one of most onerous states in U.S. when it comes to taxes, annual minimum franchise tax is $800 per year. Therefore, as soon as you're generating profits tax on which is $800 or more in a year, there is no tax disadvantage to incorporation and every advantage.
HOW DOES INCORPORATION PROTECT AGAINST PERSONAL LIABILITY?
Quite simply, when you form a corporation (or an LLC), you're forming a separate legal entity. This separate legal entity has power to enter into contracts, own and dispose of assets, hire and fire employees and generally do anything that a sole proprietor could do. The difference between corporation and sole proprietorship, however, is that only corporation's assets are at risk, not owner/shareholder's (beyond shareholder's contribution to share capital, that is).
Let's take an example. You run a part-time Internet business. You're still working a day job and this is really just a way to make a little money on side to save for your annual Hawaiian vacation and even more expensive spa stay for your dog while you're away. To you, this is only a pocket-money venture and so you don't really think of it as a business at all, really. So you don't give a second's thought to fact that you're running a business as a sole proprietor.
You register a domain name that, unbeknown to you, violates a Macrohard trademark. You create a website for that domain and, lo and behold, overnight (of course, because this is Internet) your business becomes successful beyond your wildest dreams due, in no small part, to site visitors mistakenly believing they are doing business with Microsoft's arch-rival.
Macrohard, meanwhile, sees all of this and figures your gain is its loss and sues you for an account of profits based on your misuse of its trademark. And wins. It gets a judgment for $100,000. Then it executes on its judgment. And you lose your house, your savings and your business.
Now let's look at a slightly different scenario. You're fortunate enough to have read this article before you established your business and formed an S-corporation, Hawaii Here We Come, Inc. The only asset of HHWC, Inc. is domain name and website. So, when MarcoHard gets its judgment against HHWC, Inc., only asset it can touch is domain name and website. That's bad enough, of course, but you did, after all, violate their trademark. But get this. Because they're in your name, not HHWC, Inc.'s, you still have your house and your savings.
HOW LIMITED PERSONAL LIABILITY CAN BE LOST
Merely incorporating is not enough to avoid personal liability, however. As a director and shareholder, you must run your corporation or company (if an LLC) as a separate legal entity, NOT your alter ego! This means you can't just siphon off cash from corporation's bank account to pay your house mortgage.