Chapter 20
IN THIS CHAPTER
Keeping all the paperwork in order
Watching where the money goes (and comes from)
Now, really, what is the point of a limited liability company without the limited liability part? Without limited liability, it’s no better than an expensive sole proprietorship — no special protections, no special tax treatment, no ability to issue shares of ownership. If you don’t take the simple steps necessary to keep your limited liability intact, you may as well save yourself the filing fee for creating your LLC and be prepared to kiss your hard-earned personal assets goodbye if you’re sued.
The first step to obtaining liability protection is filing the LLC. I know this point may sound elementary, and I don’t want to insult your intelligence, but plenty of extremely intelligent and accomplished individuals have failed at this first step and ended up being taken to the cleaners. Often, entrepreneurs get too busy and distracted; after all they’re running a business! They start their LLC paperwork and then leave it to sit on their desk, collecting dust, until they find the time to get around to filing it.
Because LLCs were initially created as partnerships, some states don’t even allow you to form an LLC with only one member (called a single-member LLC). Even if your state does allow the formation of a single-member LLC, don’t blur the line between what is allowed and what is advised. You may be able to form and operate a single-member LLC without a problem; however, when a business lawsuit comes up, depending on the state, the court may treat you differently than it would a standard, multimember LLC. Namely, it may not give you the benefit of charging order protection.
Charging order protection is a form of liability protection unique to LLCs that keeps your business safe in the event you get sued personally. If you’re like most entrepreneurs, your business is your biggest personal asset, so this shield may be more important to you than the standard form of liability protection!
Charging order protection has a caveat: It exists to protect partners in the business from each other, not just to protect you. After all, if you get sued and your portion of the business is seized, it isn’t fair for your business partner to suddenly be in business with some stranger, is it? Charging order protection was created to remedy this injustice, and as you can see, it only applies to true partnerships. And the one thing you need to be a partnership is a partner!
If you’re totally intent on having a single-member LLC and you’re in a state where single-member LLCs aren’t offered the same level of liability protection (see Chapter 17), then you must do what you can to look like a legitimate LLC by following all the tips in this chapter — especially the ones about having meeting minutes and a good, solid operating agreement. Don’t have a partner but still want to assure the benefit of charging order protection? I recommend that you do one of two things:
If you’ve read any part of this book, you may have a pretty good idea of how absolutely necessary I feel an operating agreement is. Your operating agreement is the backbone of your company. It creates the infrastructure and acts as an operations manual that you and your partners will fall back on time and time again to sort out the gray areas and disputes that occur during the normal course of business.
Until your operating agreement has been created, your LLC isn’t complete. Creating a comprehensive, foolproof operating agreement for your LLC should be at the top of your to-do list. LLCs are very flexible entities, and in your operating agreement you can tailor your LLC to whatever your needs are. Whether you’re raising capital, building a business, or flipping a real estate property, you’ll want different people in your organization to have different authority, and you can create a system for keeping everyone on the same page.
The phrase capitalizing the company means investing money into your business. A business without even a little bit of money isn’t really a business at all. Although I don’t like to trot out the old adage that it takes money to make money, usually you need to invest some capital to get your business going. I’m not the only one who thinks this; the courts agree.
The easiest way for a court to determine whether your company is a separate operating business or an alter ego (a company put into place to protect its owners) is to see whether you’ve invested in the business. After all, most small businesses aren’t profitable when they’re starting out, so the courts can’t base their decision on profitability. They must go on capitalization.
You must file your annual reports on time each year. If you fail to file your reports, you’ll go out of good standing with the secretary of state. If you remain out of good standing for a certain amount of time (usually a year), then your LLC will automatically be revoked, and you’ll have no limited liability protection at all. Not good!
Although annual meetings are only required for corporations and not LLCs, you must hold them anyway. If a creditor of your LLC wants to attach your personal assets to a lawsuit, he will attempt to prove one of two things:
The best defense against these attacks is to choose to go through the same formalities that corporations are required to go through. I know what you’re thinking: You’re a busy entrepreneur! How on earth can you find the time to draft meeting minutes and issue financial reports? Rest assured, though, that it won’t take as much time as you think. Not only does all this documentation help designate the LLC as a separate entity (and disprove it’s an alter ego), but it also helps prevent your LLC from being classified as a sole proprietorship or general partnership, both of which have no meeting minutes at all.
You must have annual meetings, but you also must hold a meeting whenever a major action affecting the company is to take place. When you have meetings, you must keep a record of the minutes and resolutions that take place. Meeting minutes are a record that shows that important business decisions, the resolutions, were made after a successful vote of the members. These records prove that an action of the company isn’t something some rogue member decided himself (in which case he’d likely be personally liable), but rather by the company as a whole, with all in agreement as to the course of action.
The IRS also will look to your meeting minutes to show that certain loans and financial transactions were approved. In other words, if you issue yourself a loan from the company, the IRS folks may not allow it if they don’t see it properly documented in the company’s minutes or some other form of agreement. Minutes are also good to have when requesting a ruling from the IRS, such as a 1031 exchange (for real estate investors), or defending a position to the IRS or Department of Revenue during an audit of the company or an LLC member. The minutes must also authorize any major salaries and pension contributions, contractual relationships, and elections of managers.
In addition to all these things, minutes also can be used to explain any mistakes or company oversights that may have occurred. You can state what actions the company has taken to remedy the situation. Minutes are also good for justifying why the company took a certain questionable action, such as changing the income distributions to be disproportionate to the ownership percentages. (For more information about meetings, minutes, and resolutions, see Chapter 13.)
Before opening your doors and taking orders from customers, you need to make sure that you’re squared away in the eyes of the law. Many state governments require businesses to have licenses and permits in an effort to control various industries and obtain tax revenue. Most companies only need to file a state and city (or county) business license. However, if you’re in a heavily regulated industry, such as gambling, alcohol, or land development, you need to inquire as to which licenses and permits you must obtain. (Chapter 13 covers licenses and permits in more detail.)
When you aren’t in good standing with the state and its departments, you won’t be held in high favor with the judge when he is determining whether to disqualify your LLC. If you find the ordeal of determining which business licenses you must file a bit overwhelming, contact your registered agent; she can either file the business licenses for you or point you in the right direction.
Commingling, treating your business’s funds and assets as your own, is the biggest way, by far, to kill your LLC’s liability protection. Here are a few examples of commingling:
The best way to stay on the safe side and avoid mixing your personal and business funds is by taking the following advice:
In the course of business, you’ll have to sign stuff. Lots of stuff. When you’re doing business under your company name, you must sign as a representative of the company. What this rule means is that under your signature, you must include your title and the company name, or you must write “on behalf of” and your company name. Also, always use “LLC” or “Limited Liability Company” after your company name.
Your signature should look something like this:
To avoid having the courts determine that your company is an alter ego, you need to limit your control somewhat. If you have 100 percent control over all the company’s decisions and finances, and your company does something wrong, the courts could easily hold you personally liable. This scenario is one of the most common ways to lose your liability. It happens most often in civil cases; however, the IRS has been known to force members to pay for their company’s debts on this basis.
If you’re a very small company, you often don’t have too many people making decisions on a day-to-day basis because you’re likely controlled by a small handful of people. In this case, just make sure that you don’t have any nonfunctioning managers — that is, anyone who can be viewed as your puppet — and that you observe all formalities.