What exactly is “limited liability” and why is it important? If you run your business as a sole proprietorship, from a legal perspective, there is no distinction between you and your business. You are the sole proprietor and you are essentially functioning as a business. If someone wants to sue your business, they will be able to sue you individually and go after your personal assets. However, if you form a business entity that provides for limited liability (like an LLC), you effectively shield your personal assets, activities, and interests from liability in the majority of situations. Setting up an LLC creates two distinct components: (1) the business which operates as an LLC, and (2) you as an individual. If someone wants to sue your business, in most cases, they won’t be able to sue you individually.
For example, let’s say that you work for a ridesharing company and you get in a bad car crash. Ridesharing drivers are typically engaged by the ridesharing company as independent contractors, which means that they are operating as independent businesses. The ridesharing company (e.g., Uber, Lyft, Via, etc.) simply refers customers to them and gets a fee for that. If you never set up an LLC for your driving business, you are likely operating as a sole proprietor. If you get into a car crash and the other driver involved tries to sue your business to recover damages for the crash, you could be held individually liable, meaning that your personal assets would be at risk. However, if you set up an LLC for your driving business, the LLC would shield your personal assets from that risk. If the other driver goes to sue your business, they would only be able to obtain a judgment against the assets of the LLC, not your personal assets (in most cases). This is because the LLC provides liability protection.
Once the corporate entity is set up, in order to maintain liability protection, it is important to set up an internal corporate structure that will keep the business separate from your personal assets, activities, and interests. If the business entity is determined to be an “alter ego” of the individual business owner, meaning that there is no distinction between the business owner (operating individually) and the business, the business owner might lose the liability protection of the business (this concept is called “piercing the corporate veil” of the business to hold the business owner individually liable for a legal claim). There are a number of ways in which a claimant can try to pierce the corporate veil of the legal entity. One key argument is that the business owner failed to maintain separate identities for the company and its owners. Many courts look at whether the company has a separate bank account, whether the assets of the company are treated separately from the assets of the business owners, and whether the business owners observe all corporate formalities (i.e., that they file the business taxes and required registration documents, record financials and activities in separate records, etc.). If these characteristics are present, it is more likely that the business owners would be shielded from personal liability (assuming that there is no other reason to pierce the corporate veil and disregard the business entity).
Whether or not you should set up an LLC or another legal entity that provides limited liability protection depends on what field you work in. If your field of work is less risky, then you may not feel the need to do so when you’re just starting out. However, setting up an LLC is pretty easy to do in most states and the benefits of limited liability protection are usually worth it!