Legal Matters - 2017

Liability Protection for Small Businesses

By Ketan P. Soni

Most small business owners spend the majority of their time focused on how to maximize revenue and profits. That is, of course, understandable because the entire purpose of the business is to generate revenue and profits. But focusing too much on generating revenue and controlling costs causes many owners to overlook an equally important issue – liability protection. After all, it does no good to generate profits only to lose those profits through a lawsuit that could have been avoided. Here are steps that business owners should take to minimize their liability and protect their hard earned assets.

The first step that any business should take is to organize as either an LLC or corporation. The form of business entity that a business should choose depends on a number of factors, including potential tax consequences. Small business owners should discuss these issues with their attorney and accountant to make the correct choice. It is not enough, however, to simply form a business entity. It is equally important to make sure that all corporate formalities are followed. For instance, contracts should be executed in the name of the business entity and not the name of the individual owner. The entity should maintain separate bank accounts and accounting records. Assets belonging to the business entity should not be commingled with the owner's personal assets, and business owners should not treat the company's bank account as their own personal piggy bank. Funds should only be withdrawn in the form of salary or dividends after following all corporate formalities.

Failure to follow these corporate formalities could result in the corporate structure being ignored in any subsequent litigation. If that happens, the owner will lose all protections of the corporate structure, and the owner's individual assets could also be at risk in any subsequent litigation.

When forming a business entity, one issue that is frequently overlooked is how any real estate that is used by the business should be owned. If the business owner owns the real estate that is used in the business, then that real estate should typically be held in a separate LLC. In this situation, there would be two business entities – one LLC formed to run the operating business, and one LLC that is formed solely to own real estate. The real estate holding entity can then lease the real estate to the operating business. Assuming that all corporate formalities are followed, this structure will help protect the real estate from creditors of the operating business.

Once the business entity is established, the business should obtain insurance. This insurance should include, at a minimum, commercial general liability insurance to provide coverage for bodily injury and property damage claims. Many operators of home-based businesses assume that their homeowner's insurance will also provide coverage for business losses. This, however, is generally incorrect, and the business should obtain its own separate liability coverage. Depending on the type of business, obtaining additional insurance may also be advisable. Additional types of insurance include errors and omissions insurance (for service providers) and advertising injury coverage.

Once a business entity is formed and all appropriate insurance is obtained, the business owner must also be sure to operate the business in a manner that will minimize potential liabilities. One basic step is to avoid handshake agreements. Many business owners want to avoid the time and expense of documenting all business agreements. Remember, the only way to avoid future arguments over the terms of an agreement is to put the agreement in writing. Owners should be reluctant to do business with any other party that is unwilling to put terms of an agreement in writing.

Businesses should also be very careful in their dealings with independent contractors. While independent contractors do allow a business to obtain help without incurring the costs of hiring employees, there is risk involved with using independent contractors. A business does not have the level of control over independent contractors that it has over employees. In addition, even though a business generally is not found to be liable for actions taken by independent contractors (unless the independent contractor is performing an “inherently dangerous" activity), if an independent contractor causes damages to someone else while performing an act on behalf of the business, the business will likely be sued even if it is ultimately determined not to be liable for the independent contractor's action. For this reason, any business that uses independent contractors should make sure that the independent contractor maintains its own liability insurance, and the agreement with the independent contractor should provide that the independent contractor will indemnify the business for any damages caused by the independent contractor.

Another issue that arises with independent contractors results from a business incorrectly classifying employees as independent contractors. Businesses do not have to withhold taxes or provide benefits to independent contractors. For that reason, many businesses are tempted to classify their employees as independent contractors. The IRS and other governmental agencies take a narrow view of what constitutes an independent contractor. If a business misclassifies its employees as independent contractors, it can find itself owing substantial payments for unpaid back taxes, unemployment insurance premiums, and other penalties. Some of this liability may also become a personal liability of the business owner or other person responsible for making appropriate tax withholdings on behalf of the business. Courts consider a number of factors to distinguish between employees and independent contracts. Generally, however, if an individual is providing recurring services for a business and the business has any degree of control over how the work is performed, then the business should err on the side of caution and treat the person as an employee.

Relationships with employees present another minefield of potential liabilities. Employment laws are complex and are beyond the scope of this article. As a business begins to expand and add employees, the business should consult with an attorney to obtain an understanding of its obligations and how to establish best practices to minimize employer liability.

Although business risks can never be eliminated entirely, if a business takes the actions outlined above, then its liabilities will be minimized, and the business owner will be better able to protect his or her hard earned assets.