As a business owner, there’s risk involved in building and growing your business. Risk comes in various stages of the business lifecycle, but lawsuits and bankruptcy are two risks that never seem to go away. However, there are effective ways business owners can protect their personal assets. Our strategic partner, HK Financial Services (HKFS) can help business owners, in conjunction with their trusted accountant, explore options and model various scenarios to help business owners have peace of mind.
Select the Proper Business Entity
Creating a separate business entity to protect personal assets may be the single most important step to take. The two simplest forms of business entity provide the least protection for personal assets: sole proprietorships and general partnerships. These entities are easy to form but they offer no limit on personal liability. The general partnership has even greater risk as the bad acts of one partner could translate into liability for the other partners.
The business entities that offer protection from personal liability:
- Limited Partnership – A limited partner is only liable for the amount that he or she invested. A limited partner’s personal assets cannot be subjected to claims against the business. A general partner, however, has full liability for debts and claims against the partnership.1
- Limited Liability Companies – These could be limited liability companies or partnerships (LLCs or LLPs). The business is responsible for its own debts and liabilities, but if the business cannot pay what it owes, the owners’ personal assets are protected.
- Limited Liability Limited Partnership – This entity offers some liability protection for the general partner. It is a more recent modification of the limited partnership. Slightly more than half of the states allow the formation of LLLPs.
- Corporations – S Corps and C Corps both provide asset protection to the owners.
A few words of caution with respect to corporations, LPs, and LLCs; if the business owner doesn’t keep business entity affairs separate from personal affairs, the separate entity could be considered a sham. Creditors would be able to go after personal assets for the satisfaction of debts or judgments. Some advice to avoid this risk:
- Follow the rules of incorporation. Keep up by-laws and meeting minutes. Make sure the company stays current on annual filings with the state.
- Avoid co-mingling of personal and business funds. The business checking account should not be used as a personal checking account. Lawyers seeing this may file suit based on the “alter ego doctrine,” where the company is not really a separate entity, it is an alter ego of the owner.2 This could subject the owner to personal liability. Should the owner need money, he or she should take a distribution rather than write a check from the business account.
- Keep appropriate levels of cash in the business. Underfunding or pulling too much cash out of the business may give the appearance of trying to defraud creditors.
Purchase Insurance Coverage
Businesses can protect themselves from liabilities by buying the right kinds of insurance. If there is adequate insurance on the business, claimants, and creditors may be less likely to pursue claims of personal liability.
- Errors and Omissions (E&O) Insurance – Professional service providers like financial advisors, lawyers, engineers, accountants, and so on can protect their businesses from civil liability for negligence, misrepresentation, violation of good faith, and fair dealing.3
- Malpractice Insurance – This is required for medical doctors.
- Commercial Liability Insurance – Provides coverage for injuries sustained on business premises.
- Worker’s Compensation – Provides protection for workers who get injured on the job.
HKFS can also help business owners explore coverage at the personal level. Umbrella liability coverage should be about equal to a business owner’s net worth. This coverage provides back-up if homeowners or auto coverages do not fully cover a claim.
Contribute to Qualified Retirement Accounts
Assets in retirement accounts covered by ERISA such as 401(k), 4013(b), SEP, SIMPLE, employee stock ownership, cash balance, and profit-sharing plans have unlimited protection in case of bankruptcy. Individual IRAs and Roth IRAs do not have ERISA bankruptcy protection, but they are protected from creditors to a certain extent. These accounts have the advantage of tax-deferred or tax-free growth.
Transfer Assets to Heirs
Business owners can consider transferring or gifting assets to irrevocable trusts for the benefit of one’s heirs. This puts the assets out of reach of creditors because the business owner is no longer the owner, and trusts can provide creditor protection for the beneficiaries. It also removes the assets from the estate for estate tax purposes.
Put Money into Your Home
A homestead bankruptcy exemption can protect some or all the home’s value from creditors. The exemption varies by state. It can be as low as $0 or $15,000, or an unlimited amount as in several states. Typically, no creditors except for a mortgage holder, taxing agency, or mechanic’s lien (liens placed by those who provided home improvement services, for example) may seize more of the equity than the homestead laws allow.4 If the homestead is in a state that has a high level of protection, consider paying down the mortgage to allow more equity to be protected. Similarly, in high protection states, putting more money into your home purchase offers more protection for that money.
A good defense is the best approach when creditor protection is needed. These strategies can be modeled for clients in the HKFS Guidance, Strategies, Planning (GPS) – an interactive planning program designed to help illustrate a business owner’s entire financial picture. Please contact your accountant who can arrange a meeting with HKFS to begin the GPS process.
1“Limited Partnership,” Investopedia – Small Business; https://www.investopedia.com/terms/l/limitedpartnership.asp
2 “Liability Protection,” Companies Incorporated, 2019 Companiesinc.com; https://companiesinc.com/start-a-business/liability-protection/
3 “Professional Liability Insurance,” Wikipedia; https://en.wikipedia.org/wiki/Professional_liability_insurance
4 “Homestead Exemptions by State and Territory,” Asset Protection Planners; https://www.assetprotectionplanners.com/planning/homestead-exemptions-by-state/
Investment advisory services are offered through HK Financial Services, Inc. (HKFS). Commission-based securities products are offered through Avantax Investment ServicesSM, Member FINRA, SIPC. Insurance services offered through licensed agents of HKFS. HKFS and Avantax are independent of and unrelated to Anderson ZurMuehlen. Neither HKFS nor Avantax provide tax, accounting or legal services.