How can I protect my personal assets from my business’s creditors and lawsuits?

When you own a business, you take risks that your employees will never face. If your business owes money to a supplier that needs to get paid, or if someone is suing you for a reason that has to do with your business, they could claim your personal assets. The debts in your personal life could also affect your business, to the point that it crashes.

But to fully protect yourself from risks like these, you don’t just want to rely on one trick or safety net. You’ll need a full plan, based on multiple protections, to truly make your business and your assets safe. You need to combine insurance with the right business entity, and you need to have an active way to manage your finances. These three things are like a stool with three legs. If one is missing, the whole thing falls over.

Insurance Alone Can’t Fully Protect Your Business

Why do I need all this if I already have insurance?

While insurance is invaluable - in fact, for some work, it’s indispensable - insurance alone can’t fully protect your business. For one, an insurance policy can only cover certain risks, and only up to a certain amount. And either limit could be enough to crush you. It also won’t help in a downturn and won’t protect you from your creditors if you’re unable to pay them.

While insurance policies have been created for almost every conceivable situation - even alien abduction - risks that are fairly common are often excluded from insurance coverage. Punitive damages are the classic uninsured risk. These are extra damages, above and beyond compensation, for egregious conduct worse than simple negligence.

Imagine Sally Slippery trips and falls in your icy parking lot. The icy conditions were caused by a misplaced drain and, oh yeah, seven people have already suffered similar accidents. None of the problems have been fixed. The jury awards Sally $300,000 in compensatory damages and then piles on another $500,000 in punitive damages to “punish” you for the continuing hazard.

And then, insurance policies might not pay out when you think they will. There are plenty of exclusions. For example, if you make a business interruption claim after a fire, the insurance company might deny it because the fire was in the building next door. Not only that, payouts are capped.

Say Chris Customer wins a $1.5 million judgment against you, but the limit of your insurance policy is only $1 million. That remaining $500,000 can create a lien on your assets. If you’re a sole proprietor or a partner in a business, you could lose everything - both personal assets and business assets. The judgment also can hang around for decades, nibbling away at anything you earn in the future.

Another thing to realize is that insurance policies cover specific events and occurrences, like a fire or lawsuit. They won’t help you pay your bills when you can’t. If you can’t pay your suppliers, they could sue for breach of contract and get a judgment against you. If you’re a sole proprietor, they could even levy both your personal property and business property to pay the judgment.

The Structure You Use for Your Business

You also need the next leg of your three-legged protection stool: the structure you use for your business. Separating your business assets from your personal assets is one of the most important steps you can take.

You can choose to structure your business as an LLC, a C corp, or an S corp. Or you could operate as a partnership or a sole proprietorship. The simplest structure - a sole proprietorship - puts you at the most risk. That’s because any and all of your creditors, both business and personal, could potentially collect against every asset you own. So if you operate as a sole proprietor, you’re making a huge mistake. A partnership adds only a little protection. If you help run the partnership, you’re probably a general partner.

A better approach is to form an LLC or a corporation. Either one could protect your personal assets from business creditors. The LLC provides better simplicity and flexibility. However, you should consult an attorney or accountant before you make a decision. That’s because the right choice for your situation will depend on a number of complicated factors that are unique to you.

Limited liability means that you’re only liable for your business’s debts up to the assets of the business. You’re not liable for more than that. You can even form an LLC or corporation in another state from where you operate. Some states have laws that protect LLC interests from your creditors, while a creditor could potentially take control of corporate stock. This type of protection varies by state.

But be aware that the LLC/corporation “protection” is almost always stripped away when fraud is involved, and even an innocent mistake could do that. And that’s not the only time that a creditor could reach your personal assets. For example, if you co-sign a loan for your business, then your creditor could dip into your personal bank account. Or if you commingle your business assets and payments with your personal assets and payments, you could lose your limited liability protections. It only makes sense: If you want creditors to respect the separation, you have to observe it.

Active Financial Management

Let’s look at the third leg of your three-legged stool - active financial management. As an LLC or corporation owner, your limited liability protects you. It doesn’t, however, protect the LLC or corporation’s property. All its assets are at risk of being lost to creditors. That’s why it’s best to leave as little of your wealth invested in your business as possible.

One way to do this is to create two entities, a ”holding company” and an ”operating company.” The holding company owns the assets. It leases or loans them to the operating company, which then operates the business on a day-to-day basis. This sounds complex, and it is. However, if you have a successful business or if your business is vulnerable to lawsuits - like a restaurant or a construction company - the expense and effort to set up the structure will pay off in peace of mind over the long haul.

Keep in mind that all these protections work only if your business runs lawfully and makes plans ahead of time, before things go wrong.