LLC Mistakes That Put Your Liability at Risk
Getting your LLC off to the right start is just one part of maintaining the liability benefits afforded by the business structure you’ve chosen. Once you’ve filed the paperwork and formed your LLC, you need to make sure you manage it properly.
Failing to run your business like a business or not following relevant rules and regulations can result in losing the liability protections your LLC offers. This means you could face personal liability for your company’s debts.
Here are some common missteps to avoid and ways to fix any mistakes you make.
Letting Your Operating Agreement Fall Out of Date
As part of forming your LLC, you’ll draw up an operating agreement or similar document. This spells out the terms of the LLC, describes the business and how it will operate, determines how decisions will be made and establishes other guidelines for your LLC.
The agreement you draw up when you form your LLC will reflect the needs and operations of your company when you start it. However, you might find that your company’s needs and methods of operating change over time.
It can create issues if you fail to update your operating agreement as your business changes. For example, if a member leaves the LLC, you must update your documents to account for that. Or, if you change how profits are handled, you need to update the agreement.
How to Fix It: Review and Update Your Agreement Annually
The best way to avoid this problem is to review your operating agreement regularly and update it as needed. Set an annual reminder to review the document and make any changes.
Mixing Personal and Business Finances
One of the easiest ways to lose the liability protection an LLC offers is to mix your personal and business finances. Your LLC needs its own bank account, debit cards, credit cards and other financial accounts. You should also draw a clear line between personal and business assets and tools.
If you use personal funds to pay for business expenses or business funds to make personal purchases, you risk complicating your business and having tax deductions that would otherwise be allowed, disallowed by the IRS.
How to Fix It: Maintain Separate Accounts and Respond to Mistakes Quickly
Maintaining a strict separation between your personal funds and business accounts is essential. A good way to do this is to use different banks for your personal and business accounts. You could even consider having a different wallet for business debit or credit cards and personal cards.
Mistakes happen, so if you ever use business funds for personal expenses or vice versa, you need to handle it quickly. Note any transactions where you commingled assets immediately, then figure out a way to correct the issue. If you used business funds for a personal purchase, you could simply repay the business with your personal money.
Consider consulting a tax professional for advice on the best way to correct these mistakes.
Mixing Multiple Businesses Operations/Assets
If you have multiple businesses that you manage, you need to make sure you maintain each company separately. That means having separate accounts for each entity, holding the proper annual meetings, maintaining separate records and so on.
When you mix assets of multiple businesses or don’t follow proper governance procedures for each one, you are at risk for becoming personally liable for business debts.
How to Fix It: Maintain Separate Accounts and Records for Each Entity
When you have multiple businesses, make sure you operate each one independently of the other. This means unique accounts and records for each company.
If you do mix records or accounts, do your best to untangle the mess quickly, properly record transactions in the correct records and refund money from one entity to the other as needed.
Wrongful, Reckless or Fraudulent Actions
Just because you have an LLC doesn’t mean you can do whatever you want without any personal risk. If your business takes reckless, wrongful or fraudulent actions, the courts could find you personally liable.
For example, if your LLC applies for a loan fraudulently or makes business deals with no intention or ability to follow through, these scenarios could constitute fraud. In turn, you could face penalties.
How to Fix It: Follow All Relevant Laws and Have a Clear Business Plan
To avoid this, the best thing to do is to follow all relevant business laws and rules. Don’t commit fraud or operate your company recklessly without considering how your actions could impact others.
This doesn’t mean that you can’t take risks. However, you should think carefully about the risks you take and have a clear plan for handling potential consequences. A clear, written business plan outlining how you operate and your goals can help show that you were not operating recklessly.
Undercapitalization of the Business
Your company needs sufficient assets to operate and succeed. While undercapitalization of your company typically isn’t enough to lose the liability protections an LLC offers, it can contribute to the court deciding to disregard your business and hold you personally liable.
Imagine a situation where your company cannot pay a loan and the creditor sues. The courts then find that you only left $500 in your business accounts on average and regularly took distributions from the company’s funds. They might decide that those distributions were unreasonable and make you repay the creditor from your personal funds.
How to Fix It: Make Sure the Business Has Enough Assets to Reasonably Succeed
To avoid this, make sure that your company has a reasonable amount of assets. What is reasonable depends on the nature of your business. A large company with tens of thousands of dollars in monthly expenses will need to keep more cash on hand than one that only spends a few hundred dollars each month.
If your company has sufficient assets to reasonably operate and you don’t drain it of funds regularly, maintaining your liability protections is easier.
One of the reasons to form an LLC is the liability protections it provides. Losing that protection could lead to huge unexpected costs that you have to deal with out of your personal finances. To make sure you maintain your protections, try to avoid these common mistakes and take steps to quickly rectify any missteps you make.
TJ Porter is a freelance writer based in Boston, Massachusetts. He began covering finance while earning a degree in business at Northeastern University in Boston, Massachusetts and enjoys writing about credit, investing, real estate topics. When he’s not writing, TJ enjoys cooking, sports, and games of the video and board varieties. You can contact him at find more of his work at TJPorterWriting.com