So, you’re a freelancer. Or you’re an installation artist. Or you’re a girl who gets paid to dress up like a clown and blow up balloons at children’s birthday parties. Everything is going really well, right up until the moment you get sued.
Let’s talk about when having previously formed a single-member LLC would and would not help you.
First, it’s important to understand what an LLC is and what a sole proprietorship is. A sole proprietorship is the default business entity assigned to a single-person business venture, assuming that you do not file for and register a separate business entity. It is, if not the least protective business entity, at least tied for last place with a common law partnership (which is what it’s called when you do the same thing, but with more than one person).
Almost universally, baaaaaaaad.
By contrast, a single-member LLC is a legal business entity that provides you with what’s called “limited liability" but still allows you to treat the money you make from your business as flow-through cash that you report only on your personal tax return – this is in contrast to C corporations, which suffer from what is commonly referred to as “double taxation" – you pay taxes on money made by the corporate entity and again on your personal receipts. “Limited liability" means that the owner of a single-member LLC is protected from certain business and tort obligations for which the business itself might be liable. So, you can lose the money and stuff you own as a business, but not the money and stuff you own as an individual person.
Let’s look at 3 examples:
First, in the case of the freelancer, let’s imagine a situation where work dries up and the freelancer is no longer able to afford the rent on his or her office and must terminate the lease early.
Second, in the case of the installation artist, let’s imagine a situation where the artist hires a transport company and workers to take a piece of art to a location and to install that location according to very specific instructions. The workers made a mistake, however, and the work collapses – injuring a viewer.
Finally, in the clown example, let us say that she accidentally gives a defective balloon animal to a child and it explodes, causing an eye injury.
That first case has to do with debts of the business entity. With a sole proprietorship, the business’s debts are the owner’s debts – there’s no distinction. In a single-member LLC, however, the business’s debts are usually kept separate from those of the member. Notice I said, “usually." If the member signs as a personal guarantor of the debt, the member will still be liable personally even if the business cannot cover the contract. Also, if the LLC has been poorly maintained (the owner’s personal and business accounts are mixed together, the owner does not treat the business as a separate entity, there are no bylaws or rule documents, and/or the LLC is obviously and intentionally underfunded) a court may find that the member does not deserve the limited liability protection.
In general, though, an LLC protects the member or members from being held personally accountable on business debts.
In the second case, we’re looking at vicarious liability for torts. The business will generally be liable for injuries caused by its employees or contractors within the course of their employment, and for a sole proprietorship that means personal liability, as well. With an LLC, however, the member is protected from any injuries caused by actions that he or she did not personally approve or commit. In other words, here, an LLC would protect the member from being held liable personally for the accident. The LLC, however, could still be accountable.
The last case is the flip of the second; here, the member has caused the injury. Whether a sole proprietorship or an LLC, the clown lady is going to be personally liable as well as liable as a business for the injury caused here. I put this example in because it is important to understand that an LLC cannot protect you from everything – most notably, it cannot protect you from your own actions.
Hopefully, that helps you understand whether you might want to form an LLC to protect your personal assets if something happens to your business; in most cases, the fee is nominal and the protection offered is easily worth the hassle of setting up formal business operations – which, really, small business owners should be doing, anyway.