Almost every professional freelancer eventually faces the question of whether to remain a sole proprietor or form an LLC. This is particularly important as the business grows and the potential for liability increases.
As a freelancer, you may have heard that forming an LLC provides liability protection. Understanding how liability protection works is vital for protecting you and your freelance business.
The basic difference between a sole proprietorship and an LLC is that the limited liability company is a legal entity separate from you, the freelancer. If your LLC is sued while pursuing its business, the company's assets are at risk, but your personal assets are not.
Your liability is limited because the LLC does not own your personal assets. In a worst case scenario, your company may be found liable for debts it cannot pay. In this situation, your LLC's assets will be liquidated and you will lose whatever you have invested in your business. But, you will not lose your car, your home, your retirement investments, or your life savings.
Piercing the Corporate Veil
There are exceptions, since courts can determine that limited liability does not apply in specific situations. This is called piercing the corporate veil. When courts pierce the corporate veil, individuals are held personally accountable for the liabilities of the company.
In order to properly protect both your business and personal assets, it is important to understand the ways that freelancers can have their limited liability protection set aside.
Personal Guarantees
When an entrepreneur applies for a loan from a bank, it is not unusual for the bank to require a personal guarantee to back the loan. A personal guarantee is a legal agreement that makes you personally liable for paying off the loan.
So, if your LLC is sued and you liquidate the company assets, pay what you can, and close the business - you still owe the bank, which can now seize your personal assets to satisfy the debt you owe.
Torts and the Master-Servant Rule
A tort is a civil (as opposed to criminal) wrongdoing resulting in injury to an individual, their property or reputation. Torts can be willful or the result of negligence. Imagine accidentally hitting a pedestrian with your car. This is a tort, for which you can be held personally liable.
If you happened to hit the pedestrian while conducting business, it makes no difference to the court that your LLC provides liability protection. That protection does not apply to torts.
In fact, had you hit the pedestrian while conducting business for your LLC, both you and your company can be sued and held liable for damages. This is known as the master-servant rule, or vicarious liability. Master-servant holds that because the worker was on the job when the tort occurred, both employee and employer are automatically liable.
Vicarious liability applies not only to employees but to any contractors you hire as well. As a freelancer, you can be held personally liable for a tort committed by a research assistant you hired on a contract basis if the wrongdoing occurred while the assistant was 'working' for you. This is known as negligent hiring.
Committing Fraud
State and federal laws are designed to protect honest business owners. Liability protection does not apply to business people attempting to commit fraud. In fact, the single largest factor in determining whether or not to pierce the corporate veil is the presence of fraudulent activity.
Few freelancers commit fraud. Even so, it is worth noting the possibility here to dispel the myth that business laws protect both the law-abiding and law-breaking alike. They do not.
Intellectual Property Infringement
Intellectual property infringement is always a serious concern for freelancers, as it strikes at the very heart of a freelancer's business and reputation. Even minor accusations of IP infringement can lead to a loss of business.
Whether the infringement is intentional or not, liability rests with the individual. The liability protections of an LLC do not apply to intellectual property infringement.
In fact, certain IP infringements are federal crimes, such as counterfeit trademarking, infringement of copyrighted works, counterfeit labelling and theft of trade secrets.
Keep Your Business Separate
Your LLC is a separate entity. It is critical that it stays that way in every respect. Contracts should be signed under the company name. Accounts should be opened in the company name. Advertisements, stationary, business cards, and email signatures should all prominently display the company name.
An LLC should have an Employer Identification Number (EIN) from the Internal Revenue Service. While not legally required, this is a requirement for most banks when opening a business account.
Never commingle your personal finances with the accounts of your LLC. Never purchase items for your personal use with company accounts.
Maintaining this separation demonstrates that you are running a legitimate business and not a front for fraud.
Professional Liability Insurance
You can't prepare for everything, which is where professional liability insurance comes in handy. Also known as Errors and Omissions (E&O) insurance, it covers you if you are sued for negligence. Coverage can be purchased for defense of a lawsuit, liabilities incurred from negligence (actual or alleged), as well as costs associated with copyright infringement suits.
In Summary
There are great advantages to forming an LLC as a freelancer, the most important of which is the liability protection an LLC provides. However, an LLC is not an absolute safeguard. Each LLC owner needs to be aware of the various of ways they can be held personally liable, as well as the various measures that can be taken to further protect themselves from liability.