Dave Davies here. Thanks for reaching out, to start off here are 13 Common LLC Mistakes that people make when they form an LLC.
Mistake 1: The owner(s) fail(s) to keep their finances separate from the LLC’s. Corporate income and expenses should not be comingled with personal finances.
This is the most common mistake and can have serious repercussions. Especially for Single-Member LLCs. Treating the company as your personal piggy bank causes headaches for taxes. More importantly, if you fail to treat the corporation as a separate entity, then a judge may choose to disregard it. You acted as though it didn’t exist, why should they not too?
Possible consequence for Single-Member LLC: Not every state allows Single-Member LLCs, but Wyoming does. Don’t give your creditors and the courts the chance to argue the LLC should be ignored. This is called piercing the corporate veil and generally is only possible when fraud can be proven. The LLC’s liabilities will become your own.
Possible consequence for Multi-Member LLC: Same as for Single-Member, plus membership percentages become blurred. If transfers are not documented then ownership and outstanding loans become contestable. Over time, this ambiguity could cause serious problems in case of a buy-out or liquidation.
How do you avoid this? Income and expenses should go through the LLC’s accounts. For example, in case the LLC is short of cash, then the owner should put money into the LLC’s account. Then the LLC pays its debts from its account. Do not bypass this step and do not fail to document whether the money was a loan or capital contribution.
Mistake 2: Owners fail to sign the operating agreement.
This rule applies to Multi-Member LLCs. Wyoming does not require an operating agreement. Don’t take that to mean you can skip this step however. For single owners, this agreement is between you and yourself, and is thus superfluous.
The operating agreement accomplishes several things:
The Operating Agreement should contain restrictions on transfer and a provision that gives the company a first right of refusal to acquire the interest a member desires to transfer on the same terms and conditions applicable to the proposed transfer. Other members should have a second right of refusal if the company does not exercise its first right of refusal.
Mistake 3: Members do not agree in writing about their contributions to the LLC.
Wyoming LLCs have no minimum capital contributions. Nor are Members required to make any contributions. This means Members must agree in writing regarding their contributions or you will be left with little to no recourse should they not. In our experience, if the Operating Agreement, or a separate document, do not state contribution requirements, then the agreement is unlikely to be codified in writing.
An easy example of this happening is two individuals purchasing a home. One individual takes out the loan and the second party is not named on the loan documents. The property either loses value, faces a lawsuit or sees its payments rise. In either case, the cash flow from the property becomes negative and the second party quits contributing funds. However, the first party is still liable for the entire loan, not just their share.
Agreeing in writing to contributions mean the first party could sue for breach of contract and hold the second party liable. Not agreeing means the first party has no recourse. How else can you prove what everyone agreed they would or wouldn’t be liable for?
You may contact us about a custom operating agreement or modify the complimentary one provided with your LLC.
Mistake 4: Members fail to sign a Buy-Sell Agreement.
I recommend that every multi-member LLC (other than a husband and wife owned LLC) have a Buy Sell Agreement signed by all of the owners. The Buy Sell Agreement contains the owner’s exit strategy. Without an exit strategy the members of a multi-member LLC are stuck together. We know that about one half of the people who marry will get divorced. The statistics for business divorces is higher. The lack of an exit strategy is one of the most common causes of a very expensive lawsuit between LLC owners who want a company divorce.
Mistake 5: Not Properly Funding Your LLC.
An easy example of the above is someone who buys a rental property and then forms a company. However, they fail to put the property in the LLC’s name. They keep it in their own and never change it. Now, if there is an accident, the owner is personally liable, rather than the LLC. The same logic applies to cars and other assets. Failing to properly fund an LLC can obviate its asset protection and tax features. If you never place the assets into the company, how will the IRS or courts know that’s what you intended to do. They may rule adversely and this will impact your planning.
Mistake 6: Transfers into the LLC are not properly documented.
Members have the unfortunate tendency of transferring assets into the LLC without documenting their nature. That is, was the asset/cash intended as a capital contribution or a loan?
If it’s a loan, then the LLC should sign a promissory note with repayment terms and a resolution approving the loan transaction. It should also be reflected on the books as a loan. If the payment is a capital contribution, then the LLCs book should reflect that.
For Single-Member LLCs the primary concerns are taxes and asset protection. Loan repayments are not taxable to the owner and documentation is needed to prevent the IRS from taking the position that the payment by the owner to the LLC was a capital contribution.
For Multi-Member LLCs ownership and economic rights can become blurred. What happens if no operating agreement detailing capital contributions is signed and transfers are not documented. Who transferred what and why? Will your partners agree? Will the courts or IRS? Who owns what now? Also, loans usually take precedence to equity distributions. Who gets money first in case of a liquidation?
Mistake 7: The owner fails to plan for their possible death.
All people who own an interest in an LLC will die. Almost every person who owns an LLC would like his or her spouse, family or loved ones to inherit the company when the owner dies. Unfortunately, few LLC owners plan for death and the orderly transfer of their LLC ownership to their desired heir(s).
The transfer can be simple (the LLC is owned by a trust or the owner signed a Transfer of Membership Interest Testament) or the transfer can be a time consuming, expensive and involve public probate.
Imagine your LLC has a bank account. The bank will often refuse to give control of the account to the deceased’s heirs. The heirs will have to spend money to do a probate to get appointed personal representative of the estate they will have the legal power to get control of the bank account. Do your loved ones a big favor and plan for your death so you will know for sure that your desired heir(s) inherits your LLC automatically without the need for a probate. Beyond added expenses, this could starve the company of needed cash.
Mistake 8: The LLC owns real estate or valuable property, but the property is not insured.
This is another common problem. If your LLC owns your rental property and the house burns down the insurer will deny coverage unless the LLC is the named insured on the policy, an additional insured named in the policy or there is some language in the policy that causes the LLC’s real estate to be covered. Don’t rely on that last possibility. If your LLC owns real estate or any other valuable asset talk to several business insurance agents to get their recommendations as to the type of policies, coverage amounts and other policy issues and then purchase the appropriate amount of insurance.
Mistake 9: LLC owns rental property, but the lease is between the owner of the LLC and the tenant.
Instant replay of the preceding mistake. If the LLC has title to the real estate and the landlord on the lease is the owner of the LLC guess who is will be the defendant on a breach of lease lawsuit? You got it. The owner. The lease must be between the LLC as landlord and the tenant. If the owner signed a lease before the real estate was transferred to the LLC then the owner needs to prepare a new lease that is identical to the old lease except it names the LLC as the landlord and has a new start date and says the old lease is cancelled. The owner should then tell the tenant there is a new owner of the land, i.e., the LLC, that all future rent checks must be payable to the LLC and get the tenant to sign the replacement lease.
Mistake 10: Community property law effects ownership of married Members.
Problem: Married couples incorrectly think that if they form an LLC by filing Articles of Organization that does not name their spouse as a member that the married person named as a member in the AOO will own his or her interest in the company as separate property. This is not always true and depends upon the state you live in.
For example, Arizona community property law provides that all property acquired during marriage by a married person who is a resident of Arizona is community property unless the property is acquired by gift or from an inheritance. This means that the spouse who is not named in the Articles of Organization or any other LLC document as a member automatically owns an undivided one half community property interest in the total amount of the company owned by the spouse who is named in the documents as a member.
If an Arizona resident who is married wants to own his or her interest in an Arizona LLC as separate property that person must prepare a Disclaimer of Membership Interest and get the non-owner spouse to sign the document. By signing the disclaimer the non-owner spouse acknowledges that the other spouse owns all of the membership interest as separate property.
Mistake 11: A person has a trust and personally owns the LLC instead of the trust owning the LLC.
One of the reasons people create a revocable living trust is to avoid probate. More often that not when I ask clients with a trust and an LLC if their trust is the owner of their LLC they say no. The trust must be the owner of the LLC to avoid probate on the death of a trustmaker. This means the person(s) who is the owner of the LLC has to:
(a) Sign a document that assigns the LLC membership interest to the trust.
(b) Amend the Operating Agreement to show that the member is the trust, not the person and have the trust and all the other members sign the amended Operating Agreement.
Mistake 12: A parent names a minor child as a member of the LLC.
Here are the reasons this is a bad idea:
(a) Minors do not have the legal capacity to sign contracts, including the LLC’s Operating Agreement. It is possible that third parties the LLC deals with such as a lender, a bank or a title insurance company may want to see a signed copy of the Operating Agreement, but the only way the minor can sign the Operating Agreement is if a parent gets a court order that appoint the parent as the conservator of the child’s assets. This could easily cost $2,500 – $5,000 in attorneys fees and court costs.
(b) The child would actually own the membership interest, which means that at age 18 the child becomes the sole owner of the membership interest. This means after age 17 the child could sell or transfer the membership interest or the child could get sued have have his or her credit attack the membership interest. If the child were to marry the child could convert the membership interest to community property and the new spouse would then own one half of what the child owned.
If you think the child’s membership interest currently has or might one day have a substantial value, the better way to give the interest to the child is to create an irrevocable trust for the benefit of the child. This is an especially wonderful gift and estate tax-saving device. Wouldn’t it be wonderful to give ten percent of your new LLC with little value to an irrevocable trust you create for the child so that one day when the 10 percent interest is worth a million dollars you would have avoided the gift and estate taxes that would otherwise have been incurred if you made a life time gift or a post death gift of the same amount to the child? If you need one of these trusts, call us.
Mistake 13: The company does not set up Quickbooks immediately after it is formed.
The LLC must maintain proper accounting and bookkeeping records. The lack of good books will be used against the LLC’s owner if somebody sues to pierce the veil and hold the owner liable for the LLC’s debt. Good books are needed to prepare the LLC’s tax return or to prepare the Schedule E for owners who report income and deductions on their IRS Form 1040.
This is really a no brainer. Buy Quickbooks as soon as you form your company. Get somebody to set up your Quickbooks and show you how to use it. Every year you will be able to make a tax preparer’s file to give to your tax preparer who will use the information in the Quickbooks file to prepare the tax return. The bookkeeping can quickly get out of hand if you fail to set up your bookkeeping software from day one and faithfully enter all income and expense information into it.