5 Mistakes That Threaten Your Liability Protection

You may know that doing business as a corporation or LLC can maximize your financial reward while minimizing your risk. What’s less well known is that many business owners lose this valuable protection each year by failing to follow a few basic rules and regulations.

Even if it seems like a hassle now, ensuring that your corporation or LLC is properly managed could save you from IRS audits, lawsuits, or other headaches down the road.

Whether you’re a real estate investor, an independent contractor, or a small-business owner, forming a corporation or LLC can minimize your taxes and protect your personal assets.

Unfortunately, many people start businesses without proper instruction on managing agreements between parties, creating agreements with customers, internal paperwork, cash controls, voting rules, state and Federal reporting requirements, and a host of other issues.

In particular, there are actions, behaviors, or neglected tasks that can negate the value of your business – and leave your personal assets at risk. Here are five of the most common mistakes:

1. Using the Business for Fraudulent Activities

Do I have to say it? You cannot and should not use your business to cheat or defraud. Let’s say John Smith gathers money from investors, claiming he will use it to develop a new product for his company. However, he never intended to use that money for product development. When he is sued by the investors, John claims that his personal assets are protected since he was acting as the president of his limited liability company. But, because fraud was involved, no court will honor the limited liability company. So his personal assets and business assets are at risk.

You may think that this is an egregious example. That it would never happen to you. But if, for example, you’re a real estate investor, consider the fact that many deals struck with so-called “motivated sellers” could give rise to a lawsuit under your state’s Deceptive Trade Practices Act (DTPA) or a similar statute. Sometimes the line between a good deal and fraud is not so clear, so make sure your agreements are fair.

And if you’re a small-business owner, you can’t be wholly unfair or flagrantly one-sided when dealing with your customers. As in the real estate example above, a court can look at a one-sided transaction and decide against you. Even worse, a judge could declare that you are using your business to promote unfair dealings, a far more serious charge.

Avoiding this mistake is simple. Ask yourself if you would want to be the buyer/customer on the other end of your deal. There are plenty of legal ways to structure “win-win” deals and still make great profits. Ever hear of karma? Everything you do to or for another person will one day be done to or for you. So be fair!

2. Failure to Respect the Business as Separate From Its Owners

Don’t mix funds from business accounts with your personal funds and accounts. For example, don’t use company money to buy personal assets, groceries, etc. If you do this routinely (or perhaps only once), your business structure may not hold up in court.

3. Failure to Properly Capitalize the Business

Your business must have enough insurance or savings to cover expenses, liabilities, and obligations. If it doesn’t, a state court will likely “pierce” the business entity and hold the owners personally liable. The amount of capitalization generally refers to the total value of company assets (equipment, cash, etc.) and the amount of insurance coverage. This is a complicated area, because you may need more or less “capitalization” based on your type of business. Requirements vary, but, as a general rule, the more you deal with the public, the more capital you should have available.

4. Forgetting to File State Reports

Your secretary of state’s office will require you to keep up with reports and state taxes (sometimes called franchise taxes or business privilege taxes). If you don’t (even if nominal amounts are owed), your business privileges will likely be revoked. The privilege that goes first is – you guessed it – your personal liability protection.

5. Other Formalities

Other formalities that you need to pay attention to include meetings, paperwork, required records, proper roles and obligations among the parties, and transfers of ownership interests. Make sure all of these are in order to preserve your liability protection and, if necessary, satisfy IRS auditors.

Don’t be discouraged by how easy it can be to lose your liability protection by falling into these five common traps. Knowing that they exist will help you avoid costly mistakes, keep your taxes to a minimum, and protect your personal property.

[Ed. Note: Attorney Darius Barazandeh holds an MBA and is an active real estate and tax-deed investor in Texas. He is also a leading national speaker on tax liens and corporate entities for small businesses and real estate investors.

Don’t let the possibility of making the above mistakes prevent you from getting into the real estate business. Learn more about how to set up your business correctly from the start, protect your personal assets from lawsuits, and minimize the tax bite from your investing profits. ]