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 9,200+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

13. A parent names a minor child as a member of the LLC.

Here are the reasons this is a bad idea:

(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 LLC must maintain proper accounting and bookkeeping records.  The lack of good books will be used against the LLC’s owner if somebody sues to pierce the veil and hold the owner liable for the LLC’s debt.  Good books are needed to prepare the LLC’s tax return or to prepare the Schedule E for owners who report income and deductions on their IRS Form 1040.  This is really a no brainer.  Buy Quickbooks as soon as you form your company.  Hire an experienced bookkeeper or CPA to set up your Quickbooks and show you how to use it.  Every year you will be able to make a tax preparer’s file to give to your tax preparer who will use the information in the Quickbooks file to prepare the tax return.  The bookkeeping can quickly get out of hand if you fail to set up your bookkeeping software from day one and faithfully enter all income and expense information into it.

  This is another common problem I see.  If your LLC owns your rental property and the house burns down the insurer will deny coverage unless the LLC is the named insured on the policy, an additional insured named in the policy or there is some language in the policy that causes the LLC’s real estate to be covered.  Don’t rely on that last possibility.  If your LLC owns real estate or any other valuable asset talk to several business insurance agents to get their recommendations as to the type of policies, coverage amounts and other policy issues and then purchase the appropriate amount of insurance.

  California LLC law says that a member of a California LLC is not required to make any contributions of money or property to the LLC unless the member agreed to do so in a written document signed by the member.  We have seen many companies where one or more members refused to contribute money to the company despite the begging and pleading of another member or other members.

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.

  Problem:  California married residents may incorrectly think that because a spouse is not named in the Articles of Organization filed with the Secretary of State that he or she will own his or her interest in the company as separate property.  Wrong!  California community property law provides that all property acquired during marriage by a married resident of California is community property unless the property is acquired by gift or from an inheritance.  This means that the spouse who is not named in the Articles of Organization or any other LLC document as a member automatically owns an undivided one half interest as community property in the total amount of the company owned by the spouse who is named in the documents as a member.

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.

  One of the reasons people create a revocable living trust is to avoid probate.  More often that not when we ask clients with a trust and an LLC if their trust is the owner of their LLC they say no.  The trust must be the owner of the LLC to avoid probate on the death of a trustmaker.  This means the person who is the owner of the LLC has to:

(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.

  All people who own an interest in an LLC will die.  Almost every person who owns an LLC would like his or her spouse, family or loved ones to inherit the company when the owner dies.  Unfortunately few LLC owners plan for death and the orderly transfer of their LLC ownership to their desired heir(s).  The transfer can be simple (the LLC is owned by a trust or the owner signed an Operating Agreement that provides for the transfer to a named heir on death) or the transfer can be a time consuming, Very expensive and public probate.

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.

  LLC owners rarely document properly transfers of money and property to and from the company.  The member is free to transfer funds into the LLC at will, but the failure to characterize and document transfers can have too very bad consequences for the LLC and its owner.  If Homer Simpson wants to write a check to his LLC for $10,000 he can do so at any time.  Legally, the payment is either a capital contribution or a loan, but if the owner and the company do not properly characterize the payment as one or the other the IRS or a court may do so in a way that is adverse to the owner.

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.

  We see this all the time.  The primary reason owners of investment rental property need an LLC is because they do not want to be the defendant in a lawsuit arising from a breach of the lease, somebody being killed or injured or any other claim that might arise from the property.  It is fundamental that the protection offered by the LLC does not apply and the LLC is a complete waste of money if the real estate is never transferred to the LLC.

  Instant replay of the preceding mistake.  If the LLC has title to the real estate and the landlord on the lease is the owner of the LLC guess who is will be the defendant on a breach of lease lawsuit?  You got it.  The owner.  The lease must be between the LLC as landlord and the tenant.  If the owner signed a lease before the real estate was transferred to the LLC then the owner needs to prepare a new lease that is identical to the old lease except it names the LLC as the landlord and 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, i.e., the LLC, that all future rent checks must be payable to the LLC and get the tenant to sign the replacement lease.

  We recommend that every multi-member LLC (other than a husband and wife owned LLC) have a Buy Sell Agreement signed by all of the owners.  The Buy Sell Agreement contains the owner’s exit strategy.  Without an exit strategy the members of a multi-member LLC are stuck together for life.  California’s LLC law does not provide an easy solution for LLC owners to carry out a member divorce other than through a very expensive court dissolution procedure.  We know that about one half of the people who marry will get divorced.  The statistics for business divorces is higher.  The lack of an exit strategy is one of the most common causes of a very expensive lawsuit between LLC owners who want a company divorce.

  Although California law does not require the members of an LLC to sign an Operating Agreement, the lack of an Operating Agreement signed by all members is a big mistake.  Here are just a few of the reasons why every California LLC should have an Operating Agreement:

(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.”

  This is the most common mistake I see over and over again.  The single most important legal formality of an Arizona LLC is the requirement that all of the LLC’s income must go into its bank account and all of its expenses must be paid out of the LLC’s bank account.  If the LLC is short of cash, the owner(s) should write a check payable to the LLC and deposit the funds in the LLC’s bank account so the LLC can use the funds to pay its expenses.  Don’t forget to document properly that the transfer of funds is either a capital contribution or a loan.

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.