by Richard C. Keyt, JD, M.S. (accounting), California LLC attorney & his father Richard Keyt, JD, LL.M (tax), Arizona LLC attorney
Richard Keyt formed his first Arizona limited liability company for a client the day Arizona’s LLC law became effective in October of 1992. Since then Richard Keyt and his son Richard C. Keyt have formed 8,200+Arizona LLCs. Richard Keyt now practices law with his son Richard C. Keyt who was a tax CPA before law school. In practicing LLC law the Keyts have seen people make the same LLC mistakes over and over.
The purpose of this article is to alert you to the top 13 mistakes LLC owners make (all of which can bite an LLC owner in the owner’s economic butt) so you will not make the mistakes with your LLC.
California LLC Attorney Richard C. Keyt’s List of Common LLC Mistakes
(a) Minors do not have the legal capacity to sign contracts, including the LLC’s Operating Agreement. It is possible that third parties the LLC deals with such as a lender, a bank or a title insurance company may want to see a signed copy of the Operating Agreement, but the only way the minor can sign the Operating Agreement is if a parent gets a court order that appoint the parent as the conservator of the child’s assets. This could easily cost $2,500 – $5,000 in attorneys fees and court costs.
(b) The child would actually own the membership interest under California’s Uniform Gifts to Minors Act, which means that at age 18 the child becomes the sole owner of the membership interest. This means after age 17 the child could sell or transfer the membership interest or the child could get sued have have his or her credit attack the membership interest. If the child were to marry the child could convert the membership interest to community property and the new spouse would then own one half of what the child owned.
If you think the child’s membership interest currently has or might one day have a substantial value, the better way to give the interest to the child is to create an irrevocable trust for the benefit of the child. This is an especially wonderful gift and estate tax-saving device. Wouldn’t it be wonderful to give ten percent of your new LLC with little value to an irrevocable trust you create for the child so that one day when the 10 percent interest is worth a million dollars you would have avoided the gift and estate taxes that would otherwise have been incurred if you made a life time gift or a post death gift of the same amount to the child? If you need one of these trusts, call California LLC attorney Richard C. Keyt at 480-664-7472.
The most common situation where this arises is two families decide to purchase a home to fix and flip or to rent. One family gets a loan to purchase the home, but the other family is not on the hook for that loan. Things don’t work out and the second family stops contributing one half of the money needed to pay the negative cash flow. The family that borrowed the money in obligated to make the mortgage payments without any help from the second family. If you want to create a legal obligation on a member to contribute money or property to the LLC then put the payment amounts and dates in an Operating Agreement and get all the members to sign it.
The solution to this problem is to include each owner’s future capital contribution amounts and due dates in the LLC’s Operating Agreement and have all the owners sign it. Once signed each owner can be sued for breach of contract and be liable for the unpaid contribution amount plus attorneys fees and costs. Important Note: We know from talking to many LLC owners that if the Operating Agreement with the contribution requirements is not signed immediately after the formation of the LLC it is unlikely to ever be signed in which case no owner will be legally obligated to pay any money or give any property to the LLC.
If a California resident who is married wants to own his or her interest in a California LLC as separate property that person must prepare a Disclaimer of Membership Interest and get the non-owner spouse to sign the document. By signing the disclaimer the non-owner spouse acknowledges that the other spouse owns all of the membership interest as separate property.
(a) Sign a document that assigns the LLC membership interest from the person(s) to the trust.
(b) Amend the Operating Agreement to show that the member is the trust, not the person(s) and have the trust and all the other members sign the amended Operating Agreement.
To hire us to prepare one or all of the documents needed document a transfer of a membership interest from one owner to new owner or to the LLC, call me, California LLC attorney Richard C. Keyt, J.D., CPA at 480-664-7472.
Consider a father who died owning a California LLC that had a bank account. The bank refused to give control of the account to the deceased father’s daughter, his only heir. The daughter had to spend a lot of money to complete a probate to get herself appointed executor of the estate so she had the legal power to take control of the bank account. Do your loved ones a big favor and plan for your death so you will know for sure that your desired heir(s) inherits your LLC automatically without the need for a probate.
If the payment is a loan, the LLC should sign a promissory note with repayment terms and the members of the company should sign an Action by Unanimous Consent that contains a resolution approving the loan transaction. The payment should also be reflect on the LLC’s books as a loan. If the payment is a capital contribution, then the LLCs books should reflect that fact. Whether a payment of money by the owner to the company is a loan or a capital contribution can have tax consequences. Loan repayments are not taxable to the owner. Owners need to properly document loans to prevent the IRS from taking the position that the payment by the owner to the LLC was a capital contribution.
The failure to properly document payments by LLC owners to the company can also be used by a court as one factor in favor of a finding that the company did not follow the formalities of California LLC law and that the veil should be pierced to allow a creditor of the LLC to impose a debt of the LLC on its owner. If you are ever sued and the plaintiff is trying to pierce the veil and hold you liable for your LLC’s debt to win you must prove that your LLC followed most of the legal formalities factors used by the to jury or the court in ruling yes or no on the issue.
5. A real property owner creates an LLC to own real estate, but fails to sign and record a deed that transfers title to the LLC.
(a) To prove who owns the LLC.
(b) To prove the percentage of the LLC each member owns. The Articles of Organization filed with the California does not state members’ percentage ownership. Richard Keyt formed a company for people in 1994 and sent them an Operating Agreement, but they never signed it. In 2003 they sued each other, partly because they could not agree on who the members were and how much of the company each member owned.
(b) To restrict the transfer of membership interests without the consent of the members. Without an Operating Agreement that contains restrictions on transferring a membership interest a member can transfer all or a portion of the member’s interest in the company to anybody at any time for any consideration or for no consideration. Most people do not want to wake up and find out that their “partner” transferred all of his or her interest in the company to an unknown person who now owns one half of the LLC. The Operating Agreement should contain restrictions on transfer and a provision that gives the company a first right of refusal to acquire the interest a member desires to transfer on the same terms and conditions applicable to the proposed transfer. Other members should have a second right of refusal if the company does not exercise its first right of refusal.
(c) To prevent members from disclosing confidential information about the company. Unless a member signs an Operating Agreement with confidentiality provisions, the member is free to disclose the company’s confidential information such as financial statements, tax returns and business plans.
(d) To limit the management powers of the managing member or the manager. The Operating Agreement should state what actions the managing member (in a member managed LLC) or the manager (in a manager managed LLC) can take without getting member approval and what actions require the vote and approval of all the members. Do you really want the managing member or the manager to sign a contract that obligates the company to spend big bucks or buy, sell or lease real estate without the approval of the members?
To learn more about this important LLC document read my article called “Why Your LLC Needs An Operating Agreement.”
1. The owner does not keep the LLC's income and expenses separate from the owner's income and expenses.
The reason this is potentially the worst LLC mistake is because in a lawsuit brought by a plaintiff to pierce the veil and hold the owner liable for the debts of the LLC the failure to follow this rule could be the primary reason the court pierces the veil and holds the owner liable for the LLC’s debts. Here are the rules and take care to always follow them:
(a) All income payable to the LLC must be deposited into the LLC’s bank account.
(b) No income payable to the LLC should be paid to the owner and deposited into the owner’s bank account.
(c) The LLC must pay all of its expenses from its bank account.
(d) The owner may not pay any of the LLC’s bank account with the owner’s funds.
(e) If the LLC needs money, the owner should pay the funds to the LLC as a loan or a capital contribution.
(f) If the owner needs money and the LLC has excess funds, the LLC should write a check payable to the owner and the owner should deposit the check in the owner’s bank account. The LLC must reflect on its books that the payment is either a return of capital, a distribution of profits or a repayment of a loan.