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, and no ability to issue ownership shares. 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.

Before you even think about taking extra steps to protect your limited liability, I ask you to do one thing: Be on your best behavior. No, I don’t mean keep your elbows off the dinner table and say “please” and “thank you.” I mean, don’t lie, cheat, or steal in the name of your LLC. Wrongful misconduct on the part of a member is the easiest way for your LLC’s veil of limited liability to be pierced. Don’t think that your company will protect you from purposeful fraud that you initiate.

File the LLC Properly

The first step to obtaining liability protection is filing for an 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.

If this description makes you think I’ve been spying on you (I haven’t), you should hire a formation company to file the documents for you. You don’t even have to sign anything (except maybe the check to pay the company!). In most states, your formation company can list itself as the organizer — a temporary position that only lasts until the company is filed — and handle the entire process for you. The fee is normally small, and they can get this incredibly important task off your plate.

Situations often arise when you want to file quickly and don’t have time for preparation. Remember that when you rush to file, you risk getting your articles of organization rejected because you didn’t do the requisite research and preparation. Also, you should take time to attach to your articles certain provisions, such as the limited liability provision and the charging order provision, that aren’t included in the state’s generic articles of organization.

Find a Partner

One of the best features of an LLC is dual-liability protection (charging order protection). But 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? Because this is the reasoning behind charging order protection, most states don’t automatically provide this to single-member LLCs. After all, LLCs with only one owner do not have a partner who needs this sort of protection.

Charging order protection is a form of liability protection unique to LLCs that keeps your business safe if 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!

A handful of states have charging order protection baked into single-member LLCs: Alaska, South Dakota, Nevada, Delaware, and Wyoming. If you are a single-member LLC and your LLC is domiciled in any other state, you may want to bring on a partner if charging order protection is important to you.

Any partner you bring on does not need to be equal. They (in the case of another entity being the partner) could theoretically own a very small percentage. Here are two possibilities that may work for you:

• Find a friend or family member you can trust and issue them a small membership percentage. Make sure you have a contract or that your operating agreement states they can’t sell or transfer the shares without your approval. Because they aren’t contributing anything to the business, you can also state in your operating agreement that they get a very small percentage of the distributions.
• Form a corporation you can control — preferably in a tax-free state — and make the corporation your second partner in the business. Remember, LLCs can have anyone as a member, and members don’t even need to live in the same country.

If you want a surefire way to completely protect your LLC, you should have more than ten members. Historically, any organization with more than ten members has never had its veil of liability pierced or its charging order protection tossed aside by the courts. If you have more than ten members, you should be in the clear, no matter what.

Create an Operating Agreement

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 you can tailor your LLC to your needs in your operating agreement. 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.

State law gives LLCs an incredible amount of leeway for how they want to be structured and operated, but without an operating agreement in place that includes all specifications, your LLC must abide by the state’s default laws. These laws are often strict, unfavorable, and offer very little liability protection. That’s why you must create an operating agreement for your LLC before engaging in any sort of business. You can create a customized agreement in less than a day, so don’t put it off because you think it will be difficult! In Chapter 8, I get you started on creating this über-important document.

Capitalize the Company

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, you usually 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.

What if you’re starting small and didn’t invest any money into your LLC? In this case, if you can show substantial cash flow and prove that your business is operational and regularly deals with the public, then you have a good chance of being in the clear. Make sure you have a reason for your shares being issued to you, whether for services rendered, assets given, or money invested. You must put this information in your meeting minutes.

File Your Annual Reports

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), your LLC will automatically be revoked, and you’ll have no limited liability protection. Not good!

The filings are often one page and require minimal information, such as the names and addresses of the LLC’s members and/or managers, the name and address of the LLC’s registered agent, and the corporate office address (Chapter 12 has more details about annual reports). You either file your annual report with the same state office with which you filed your articles of organization— in most states, it’s the secretary of state — or the state tax board. Your registered agent should be able to provide the exact information regarding what’s required to maintain your LLC in a particular state. (Flip to Chapter 4 for details on registered agents.)

Hold Member Meetings Regularly

Although annual meetings are only required for corporations, not LLCs, you must hold them anyway. If a creditor of your LLC wants to attach your personal assets to a lawsuit, they will attempt to prove one of two things:

• Your LLC is an alter ego.
• Your LLC appears to be a sole proprietorship or general partnership and should be treated as one.

The best defense against these attacks is to go through the same formalities that corporations must 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 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. Meeting minutes are a record showing 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 themselves (in which case, they’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 will also review 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 a company or LLC member audit. 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 12.)

Obtain Your Licenses and Permits

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. To control various industries and obtain tax revenue, many state governments require businesses to have licenses and permits. 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 must inquire about which licenses and permits you must obtain. (Chapter 12 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 they are 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; they can either file the business licenses for you or point you in the right direction.

While applying for your state licenses and permits, don’t forget the ever-important federal employer identification number (also called an EIN or a tax ID number). Think of it as a Social Security number for your LLC. Until you obtain an EIN, you can’t do much business. Applying for a number online at the IRS’s website (www.irs.gov) is incredibly easy, as I explain in Chapter 7.

Avoid Commingling Funds and Assets

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:

• You use the funds from your business for obvious personal expenses without documentation. For example, getting your teeth bleached is not a business expense unless you’re a model or newscaster. Good try!
• Your personal bank account and your business bank account are the same.
• You endorse checks to yourself that are made payable to your business.
• You often move money between your business and personal accounts without keeping proper records.

If you’re treating your company account as your personal piggy bank, stop. Not only do you risk being heavily penalized by the IRS, but you also risk losing your personal assets and livelihood should you ever get dragged into court. If the courts decide you’re treating your money and the company’s money as one and the same, they can easily disregard your entity as not being separate from you — hence the term alter ego.

The best way to stay on the safe side and avoid mixing your personal and business funds is by taking the following advice:

• Make sure your LLC has its own bank account.
• Don’t use the business money to pay for personal items. If you absolutely must, then carefully document it on the company’s books.
• Don’t pay yourself indiscriminately. The money you receive from the company should be a loan, salary, or distribution.

Sign Your Documents Correctly

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 company representative. This rule means 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:

• Your signature
• Your name
• Your title (Manager or Member)
• Your LLC Name, LLC

The Wurzburg Bros. Inc versus James Coleman case shows how important signing documents correctly is. In this case, James Coleman was the president of Coleman American Moving Services, Inc. When the company was behind on its payments to Wurzburg Bros., Inc. (one of its vendors), Mr. Coleman sent a promissory note to ease the tensions. When he signed the promissory note, he failed to put his title and the company name under his signature. Wurzburg Bros. successfully sued James Coleman, the person, and succeeded in taking his personal assets to cover the judgment.

Give Up Some Control

You must somewhat limit your control to avoid having the courts determine that your company is an alter ego. 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 a small handful of people likely controls you. 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.