The formation of a limited liability company (LLC) is a common legal tool, and for good reason. LLCs provide valuable legal protections to their owners, referred to as “members,” by separating the members’ personal assets from the liabilities and legal obligations of the LLC. LLCs also provide tax advantages by allowing members to report the profits of the LLC on their personal tax returns. Without this “pass-through” taxation, the LLC would pay its own income taxes before the members separately paid personal income taxes on the profits distributed to them. Although LLCs can be valuable legal tools, if they are not managed properly, they can cause more harm than good.
Below are 5 common LLC mistakes made by members of newly-formed LLCs – and how to easily avoid them.
(1) Failure to Separate Personal Assets
Even though LLCs are flow-through entities for tax purposes, members should never commingle their personal assets with those of the LLC. A failure to keep the LLC’s assets separate from the personal assets of its members will not only muddle corporate recordkeeping, but could also be interpreted as a disavowment of the LLC’s legal structure – which could threaten the members’ limited liability protection. After incorporating a new LLC, set up a separate bank account for it. This will require a Federal Employer Identification Number from the IRS, which can be obtained online in a matter of minutes.
(2) Failure to Enter into an Operating Agreement
An operating agreement is a binding agreement between the members of the LLC that governs its operating procedures, as well as the rights and responsibilities of its members. For example, the operating agreement clearly defines voting rights, how major decisions will be made, how disputes will be resolved, and what happens in the event of a member’s departure or death. When members fail to agree upon and formalize these items at the outset, they are likely to encounter misunderstandings and disagreements in the future, which could result in costly litigation. Even if you are the sole member of your LLC, it is important to have an operating agreement in place because, in the absence of an operating agreement, the LLC will be subject to default state rules, which may not align with your intentions or desired business practices. An experienced attorney can prepare an appropriate operating agreement at minimal cost.
(3) Failure to Properly Enter into Third-Party Contracts
For any third-party contracts related to the LLC’s business, the contracts should always be entered into by the LLC – not by any member in a personal capacity. Although an authorized member will sign the contract, the contract should specify that the member is signing on behalf of the LLC in a capacity as an authorized member. If the contract does not include this specification, purchasers, suppliers, or other third parties could hold the member personally liable for a contract that was intended to bind the LLC. An experienced attorney can review and revise third-party contracts at minimal cost.
(4) Failure to Maintain Adequate Funds
LLCs, like individuals, can benefit from maintaining an emergency fund for several reasons. Unexpected expenses can arise at any time during the course of running a business. These might include equipment breakdowns, property damage, pandemics, natural disasters, economic downturns, or industry-specific disruptions. An emergency fund allows the LLC to cover these expenses without jeopardizing its day-to-day operations or resorting to high-interest loans or credit. In addition, an emergency fund allows the LLC to quickly seize any unforeseen business opportunities without relying on external financing or compromising financial stability. The amount of the emergency fund should be based on the specific needs and circumstances of the LLC – and should generally cover at least 3 months of operating expenses.
(5) Failure to Obtain Appropriate Insurance
Insurance is an essential component of risk management for an LLC. It helps identify, assess, and mitigate potential risks associated with the business. Without adequate insurance in place, the LLC will be on the hook for unforeseen events such as accidents, property damage, theft, or professional errors and omissions. By obtaining appropriate insurance coverage, the LLC can transfer these risks to its insurance provider. In addition, third-party contracts are likely to require the LLC to maintain certain types of insurance coverage. By keeping appropriate insurance coverage in place, the LLC can comply with contractual obligations and provide peace of mind for its members.
If you have any questions about how to properly form or manage an LLC, please contact Cincinnati business attorney Jeff Levine at JALevine@strausstroy.com or 513-629-9425.