Common LLC Mistakes that Risk Your Personal Liability Protections

Starting a business is a bit like baking a cake — you need the right ingredients, a good recipe, and a pinch of patience. But unlike a cake, a business can have serious legal implications if handled incorrectly. This is where forming a Limited Liability Company (LLC) comes into play.

Now, we’re not lawyers, so be sure to discuss the legal aspects of forming an LLC with a licensed attorney. But according to LegalZoom:

“When you form an LLC, you establish a new business entity that’s legally separate from its owners. This separation provides what is called limited liability protection… If the LLC can’t pay its debts, the LLC’s creditor can go after the LLC’s bank account and other assets. The owner’s personal assets, such as cars, homes, and bank accounts are safe.”

There are exceptions and some common mistakes you might make that weaken an LLC’s protective powers. Let’s dive into these pitfalls and how to avoid them so you don’t risk your own liability and keep the LLC personal liability protection intact!

LLC Mistake #1: Not updating your operating agreement

Your operating agreement is the rulebook for your LLC, outlining who makes financial and operational decisions for the business and how you split profits and losses (if there’s more than one business owner). While some states don’t require LLCs to have an operating agreement, having one is a good idea.

As your business evolves, so should your operating agreement. For example, if you bring in new LLC members, an existing LLC member retires, or you decide to split profits another way, you should update your agreement to reflect these decisions.

Failing to update it can lead to legal ambiguities and disputes, which could mean you’ll be held personally liable for business debts and lawsuits. Yes, even though you have an LLC, your personal assets could still be at risk by making this mistake.

The fix: Regularly review and amend your agreement to reflect changes in your business structure, member roles, and operations. Think of it like updating your GPS — you wouldn’t want to navigate today’s roads with a map from 10 years ago, right?

LLC Mistake #2: Mixing business and personal finances

For any business, keeping business and personal finances separate is essential. Having a separate business checking account and business credit card makes it easier to track your business finances, file accurate tax returns, and successfully deal with an IRS audit.

For limited liability companies, it’s especially important to avoid commingling business and personal finances, as it can compromise your liability protection. If your business faces a lawsuit, blurring the lines between your personal and business finances can lead to a legal concept called “piercing the corporate veil.” This means your personal assets could be at risk if your business is sued.

The fix: Keep your business and personal assets separate. Open a separate business checking account and business credit cards and use them only for business expenses.

Of course, mistakes happen, and most LLC owners have accidentally paid a personal expense with their business card or vice versa. When this happens, issue a reimbursement and document the mix-up. These mistakes should be non-habitual. 

LLC Mistake #3: Combining finances or assets of multiple businesses

There’s just something about entrepreneurs. If you’re the type of person who recognizes an opportunity and feels like you’re the one to fill a hole in the market, it’s easy to go from running one business to juggling two, three or four businesses at once. Be careful though – this sort of behavior can easily risk personal liability for all business and negate any protections afforded by your LLC.

For example, if one business goes belly up or is the subject of a lawsuit and you’ve combined the finances of multiple business entities, creditors might be able to go after the assets of those other entities. Running multiple businesses under one LLC is like juggling flaming torches — it’s risky and can lead to significant liability issues.

The fix: Create a separate legal entity for each business venture and keep each entity’s finances and business debts separate. This isolates the risks and keeps the liabilities of each business distinct.

Again, mistakes happen. If you accidentally grab the wrong debit card when making a purchase, just have one entity reimburse the other. Then hold on to that documentation in case you ever need to prove you’re following corporate formalities.

LLC Mistake #4: Acting recklessly or fraudulently

This should be a no-brainer, but it’s worth mentioning. Engaging in illegal or fraudulent conduct tarnishes your reputation and can dissolve those LLC protections.

For example, say you falsify documents to get a business loan and then can’t repay the loan. If your business creditors can show you committed fraud, you could be held personally liable for repaying the loan even if you didn’t personally guarantee it.

The fix: Always operate within the law and uphold ethical business practices. Remember, a good reputation is like a garden — it takes time to grow but can be ruined in a moment.

LLC Mistake #5: Undercapitalizing the business

It’s expensive to start a business. Many costs are involved, from renting space to buying commercial general liability insurance and hiring employees to investing in business assets and inventory.

Make sure you adequately capitalize the business. What does this mean? It means the business has sufficient capital (i.e., money) to cover its foreseeable operations and obligations. That capital can come from money and other property invested in the business by its owners or money loaned to the company by founders, other private parties, or financial institutions.

In short, starting a business without sufficient capital is like trying to drive a car without gas — you won’t get very far. It can lead to financial instability, putting your personal assets at risk.

There’s no magic number for how much you need to invest in your business for it to be adequately capitalized — it depends on your industry, operations, and risk.

For example, if you have a business idea that reasonably would take a $1,000,000 investment to get off the ground. If, instead, you only have $100,000 of capital in the business and the company fails, the courts could find you didn’t adequately capitalize the business and hold you personally liable for business debts.

The fix: Work with your accountant and other business advisors to forecast operating revenues and expenses and research similar businesses. Ensure you have enough funding to cover your business operations without cutting corners.

Protect your personal assets with sound business practices

Forming an LLC is a smart move for protecting your personal assets, but it’s not a set-it-and-forget-it deal. Regular maintenance, ethical practices, and clear financial boundaries are essential to keep your liability protection strong.

If you’re feeling overwhelmed or unsure about how to navigate these waters, please reach out. We can work with your legal advisors to help you separate business and personal assets and decide how much capital you need to get started. When you know you’ve followed the rules, you’ll be ready to take on the world of entrepreneurship with confidence.

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