A Limited Liability Company (LLC) offers its owners the benefits of a corporation and a partnership. Like a corporation, LLC owners are typically not personally liable for the business’s debts and liabilities. The LLC also benefits from being a pass-through entity, meaning profits are passed directly to the tax returns of the LLC members, and the LLC does not pay taxes on its income. By combining a partnership’s flexibility and a corporation’s liability protections, an LLC allows its owners to focus on growing the business. However, this hybrid business entity is not risk-free. Many of the typical mistakes corporations or partnerships make can also be made by an LLC. Below are the common mistakes LLC owners make and how to avoid these pitfalls.
- Failure to Draft an Operating Agreement
As a new LLC owner, it is encouraged that a comprehensive operating agreement be signed between all organization members. An operating agreement establishes the internal rules, roles, and expectations for those managing the business and dictates how unanticipated circumstances will be handled. If a member wishes to withdraw from the LLC, unexpectedly passes away, or a new member desires to enter the organization, the operating agreement will have provisions for the event. Examples of other essential elements commonly found in an operating agreement include provisions on how the LLC will be dissolved, how member disagreements will be handled, and how profits and losses will be allocated.
Moreover, not drafting an operating agreement can leave an LLC subject to the default laws of the state. These rules will dictate profit distribution, voting rights, and management structure. These default laws are often “one-size-fits-all” type of rules, therefore not making them well-suited for an LLC’s specific needs.
- Failure to Keep Personal and Business Finances Separate
One of the attractive features of an LLC is the protection it offers against personal liability. Generally, if the LLC is sued or defaults on its liabilities, the members’ assets will be protected from collection. However, failure to keep the company’s finances separate from the member’s personal assets could “pierce the veil” of the LLC. LLC owners can find themselves in trouble if they commingle their personal funds with those of the LLCs, making it impossible to determine where the company’s bank account begins and where the member’s account ends. The LLC’s money should not be treated as the member’s money. LLC owners should take the necessary formalities to preserve the LLC as a separate legal entity. This may include opening a business checking account, obtaining a business credit card, and keeping accurate financial records.
- Failure to Correctly Enter into Third-Party Contracts
Not only is it important to keep personal and business finances separate but so is maintaining contracts with third parties. LLC members should not enter into contracts with third parties in a personal capacity. While the member’s name will be included in the contract when signing, it should specify that the member is signing the contract as an authorized agent of the LLC, not as an individual. Failure to take this critical step could open LLC owners to personal liability because vendors, distributors, and suppliers will seek payment from the individual members named in the contract.
- Failure to Properly Capitalize the LLC
Sufficient funds allow an LLC to cover operational costs and manage potential setbacks. LLC owners can miss significant business opportunities if they cannot pay suppliers, creditors, employees, or other operational expenses. Undercapitalization can also lead to a higher risk of bankruptcy or insolvency. When courts determine whether to “pierce the veil” of a business, one common factor across states is seeing if the business entity was adequately capitalized. Having extra capital is similar to an emergency fund individuals have when unforeseen circumstances arise. Whether equipment breaks down, a natural disaster destroys property, or a pandemic disrupts operations, having an emergency fund makes these challenges manageable.
- Failure to Obtain Necessary Insurance
LLC owners can manage risks by obtaining proper insurance coverage. If an accident occurs on the premises, a natural disaster causes structural damage, or an employee needs to take leave for a personal matter, the risk and costs of these events can be transferred to an insurance provider. Moreover, the state the LLC is organized in may mandate it to have specific insurance policies. For example, New York requires LLCs to obtain workers’ compensation insurance.
Takeaway
While an LLC provides valuable benefits like liability protection and tax flexibility, avoiding common mistakes is critical to success. LLC owners should prioritize drafting a thorough operating agreement, separating personal and business finances, entering contracts correctly as agents of the LLC, obtaining necessary insurance, and ensuring the company is adequately capitalized. Overlooking these key areas can expose members to personal liability, legal disputes, or financial instability. By taking proactive steps to manage risks and adhere to formalities, LLC owners can safeguard their business and confidently focus on growth.