If you invest in real estate or own a business, you may have heard that you need to set up a limited liability company, commonly known as an LLC, in order to protect your assets. However, many people mistakenly think an LLC is a magical silver bullet to asset protection. An LLC is not a guaranteed asset protection device. People often make mistakes when they set up their LLC which negates the asset protection.
This is the second article in a two part series. The first article discussed five common mistakes. Read the list of four more mistakes below.
Mistake #6: The Member does not keep the LLC’s income and expenses separate from the owner’s income and expenses.
This is the most common mistake I see repeatedly. An LLC is not a personal slush fund. Its income and expenses need to be kept separate. The single most important legal formality of a LLC is the requirement that all of the company’s income must go into its bank account and all of its expenses must be paid out of the company’s bank account. If the LLC is short of cash, the owners should write a check payable to the company and deposit the funds in the company’s bank account so the LLC can use the funds to pay its expenses. Do not forget to document that transferring funds is a capital contribution or a loan. The reason this is potentially the worst mistake is because if there is mixing between personal and company assets, the Court could disregard the LLC and hold the Members personally liable for the debts of the LLC.
Mistake #7. A Member contributes money or real estate to the LLC but does not document the transfer.
It is a mistake when Members do not document transfers of money or real estate to and from the LLC. The Member may transfer funds into the LLC at will, but failing to characterize and document transfers can have bad consequences for the LLC and its owners.
Example 1: You give $50,000 to your LLC. The payment could be considered an initial capital contribution, an additional capital contribution, or a loan. If the Member and the LLC do not correctly characterize the payment, the IRS or a court may do so for the Member. It is a good bet the characterization will not be in a way that will most benefit the Members.
Example 2: You own real estate in your individual name and never execute a deed to transfer it to the LLC. Unfortunately, this is a frequent mistake. The primary reason owners of investment real estate establish an LLC is avoid being an individual defendant in a lawsuit when a dispute arises over the real estate or its use. The protection offered by the LLC does not apply because the real estate is not owned by the LLC. The time and money expended to form the LLC and maintain it is of no use because the real estate was never transferred to the LLC.
Mistake #8: Lease does not list the LLC as the Landlord.
The LLC owns investment real estate and there is a real estate lease. It is a mistake if the lease is between the individual Member as landlord and not in the name of the LLC. This is similar in result to the preceding mistake noted above. If the LLC has ownership of the real estate and the landlord on the lease is an individual member of the LLC, the defendant in a dispute involving the lease is the individual not the LLC. The lease must be between the LLC as landlord and the tenant. If the Member signed a lease before the real estate was transferred to the LLC, the owner must prepare a new lease that is identical to the old lease except it names the LLC as the landlord, has a new start date, and says the old lease is cancelled. The owner should then tell the tenant there is a new owner of the land, that all future rent checks must be payable to the LLC and get the tenant to sign the replacement lease. Another option is to have the individual member assign the lease to the LLC, if the lease does not require the tenant’s consent to the assignment.
Mistake #9: No Buy-Sell Agreement.
Every multi-member LLC should have a Buy-Sell Agreement signed by all of its Members. The Buy-Sell Agreement should contain provisions stating what happens if a Member passes away, becomes mentally incapacitated, or wants to retire. Without an exit strategy, the members of a multi-member LLC gamble that everything will work out just fine. Florida law provides no way for Members to allow for the exit of a Member other than an expensive and time-consuming court dissolution. The statistics for business failures can be higher than divorces. The lack of an exit strategy is a common cause of a costly lawsuit between Members, some or all of whom do not want to be involved with the LLC any longer.
This article is for general information only and is not intended to provide legal advice. The above list is not intended to be an exhaustive list of mistakes. If you think you have made some of these mistakes, sometimes they can be repaired. Members should consult with a business law attorney. Call us at 813-852-6500 to schedule a free 30-minute consultation.