"Do-it-yourself" legal has exploded in popularity over that last couple of years. Given the cost savings and instant gratification of the internet it is no wonder small business owners are increasingly side stepping lawyers to form their business entities. If you decide to go at it alone make sure to do your homework. The cost savings can quickly dissipate without proper planning. Listed below are the seven most common mistakes I see LLC owners make and what they should do to avoid them.
1. Using the Wrong Signature Block.
There is a formal procedure an individual must undertake when executing documents on behalf of a corporation or LLC. One of the easiest ways that an LLC member can call his or her personal liability into question is for that member to improperly execute documents which are meant to solely bind the LLC. See, Zukel v. Great West Managers, LLC, 78 P.3d 480 (Kan. App. 2003). In Zukel, the managing member of an LLC was held to be personally liable on a contract between the plaintiff and the LLC. The Court specifically noted that the member neglected to use the proper mode of execution when signing the document in question, but had properly executed other documents involved with the transaction. Any document that a member is signing on behalf of the LLC should always be executed in the following manner: State the name of the LLC, followed by the name of member or officer with capacity, preceded by the words “per” or “by”, and followed by the title of the member or officer. For Example:
By: John Doe, Member
This procedure needs to be followed on every single document. As the case above illustrates, courts will look to varied forms of execution as evidence for intent to be held personally liable. It should be noted that Kansas courts will always try to ascertain the intent of the parties by analyzing the contract as a whole. Therefore, if you unambiguously agree to be held personally liable as a member in the body of the contract, chances are that you will not be able to get out of that personally liability solely by using the signature block above. The main point to be taken away from here is that by deviating in any way from the execution example above you are giving the creditor of your LLC an excuse to come after you personally if a dispute arises. The creditor may not ultimately be successful be it is much less costly to properly execute a document than it is to defend a lawsuit.
2. Neglecting To Utilize An Operating Agreement.
In Kansas, executing an operating agreement is not necessary to form a limited liability company. If an LLC does not employ an operating agreement it is deemed to be governed by the default rules of the Kansas Revised Limited Liability Act (“Kansas LLC Act”). The problem with this is that most Kansas business owners do not have the time or inclination to read and interpret Kansas Statutes. If members are unaware of the contents of the Kansas LLC Act chances are they are not operating their LLC in conformance with the statues. This not only exposes the members and managers to liability among each other it potentially exposes the members to personal liability under a piercing the corporate veil argument. By adopting an operating agreement the members can modify the default rules of the Kansas LLC Act to fit the company’s specific needs, as well as, provide an easy to follow blue print for all the members to follow. If you adopt an operating agreement make sure you understand and follow it. Two of the factors that favor disregarding a corporate entity in a personal liability action are: (1) failure to follow corporate formalities and (2) absence of corporate records. So if your operating agreement requires a majority vote of the members to enter into transactions on behalf of the LLC, the members must then go to a vote before any business transaction can take place and the vote should be documented in writing. This would no doubt prove to be a time consuming process and that is why you need to understand what you obligating yourself to before you sign an operating agreement.
3. Failing to Consider Estate Planning Implications.
This is another situation that is fairly painless to account for when forming your LLC but can be extremely costly and time consuming if it is left unaddressed. One’s impending death is never a fun topic to think about, but failing to account for it can leave your family and business in a state of flux if the unthinkable does happen. This is especially true in the case of the single-member LLC. One of the easiest things the sole owner of an LLC can do to avoid potentially costly probate proceedings is to make a payable on death designation on the member’s LLC certificate. Upon the member’s death the LLC interest will pass automatically to the beneficiary who can then step in and continue to manage the affairs of the business. In contrast, consider the case of a single-member LLC owner who unexpectedly dies without a will and is survived by a spouse and a minor child. Without a will or beneficiary designation there is no mechanism in place to transfer ownership to the spouse or a designated manager to run the business in the deceased member's place. This is especially problematic if the business is the family’s sole source of income because there is no longer anyone who is authorized to contract with suppliers, sign off on loans or lines of credit, or to simply manage the day-to-day affairs of the business. To gain control of the business the spouse must now turn to probate which becomes even further complicated because a minor child is involved. Under Kansas intestate succession laws the minor child and the wife each own a ½ interest in the LLC interest and a guardian ad litem may need to be appointed to protect the minor child’s interest.
4. Co-Mingling Company and Individual Funds.
One of the most tempting things for a business owner to do is pay for personal items out of company funds. Before heading to Target or paying the mortgage make sure you transfer the amount of money you need out of the LLC’s bank account and deposit it into your own. The timing and amount of distributions to be made to LLC members is largely a management issue, and a properly drafted operating agreement can grant members a wide range of flexibility in taking distributions should they ever get in a pinch. The caveat here is that if you already have an operating agreement in place dictating the timing of distributions, you must follow the procedure in the operating agreement. Therefore, know thy operating agreement well and plan and budget your expenses to the best of your ability. The moment you start paying for corporate items with personal funds or vise versa you are adding ammunition to any personal liability action that may someday be brought against you.
5. Backdating Organizational Documents.
In today’s economy more and more small business owners are finding themselves under the increasing threat of litigation from their creditors and suppliers. When most business owners find that their corporate records are lacking their first reaction is to go back and recreate the documents they may need in anticipation of litigation. Whether a business owner can do this or not all depends on if the events being described in the recreated documents actually occurred. For example, let assume that six months prior members of an LLC held a properly called meeting and received a sufficient amount of affirmative votes to sell a major asset of the LLC. Due to inadvertent mistake and the member’s busy schedule the minutes from the meeting were never recorded and placed in the LLC record book. Six months later when the members' realized their mistake they drafted minutes which accurately depicted what occurred during the meeting and dated the document as of the six months earlier. This process is known as “memorializing” and is perfectly acceptable. In, contrast let’s assume the members of the LLC never held a meeting and the method in which they sold the asset did not confirm with the procedure as set out in the LLC operating agreement. Realizing that they may have a problem, the LLC members quickly draft and sign off on minutes dated six months earlier for a meeting that never technically happened. This is a clear case of backdating that fabricates and needless to say it can get you into all kinds of trouble. Fraud not only opens up a claim for punitive damages, it is also a major factor Kansas courts analyze in determining whether or not to disregard an entity’s corporate status. When fraud is present the courts almost always are more likely to disregard a corporate entity and hold the members personally liable than if that fraud did not exist.
6. Forgetting to File Annual Reports.
Every LLC formed in Kansas to file an annual with the Kansas Secretary of State providing: (1) the name of the LLC and (2) the names and addresses of all members owning at least 5% of the company. The annual report may be signed by any member of the LLC under penalty of perjury. For companies whose tax year ends on December 31st, the annual report is due on April 15th. The technical calculation is the 15th day of the 4th month following the end of the LLC's tax year. If an LLC fails to file its annual report within 90 days of the report’s due date the articles of organization of the LLC will be deemed forfeited. Forfeited articles may only be reinstated by filing a certification of reinstatement along with all delinquent annual reports with the secretary of state. Forfeited articles means that the LLC loses its limited liability status and as such the members are no longer personally protected from the obligations of the company. In reality this isn’t as harsh as it sounds. K.S.A. 17-76, 146(c) provides that once you reinstate an LLC it relates back to the 1st day when the LLC was forfeited. This means that so long as the members take the proper actions to reinstate the LLC, it will be as if the LLC never lost its limited liability status. With that being said, an extended history of forfeited status may reflect poorly on the members and it is always much simpler and cheaper to file your LLC’s annual report on time rather than messing with the reinstatement process.
7. Transferring Assets Under the Threat of Litigation.
Members should never transfer assets in or out of an LLC without first considering the impact of the Kansas Uniform Fraudulent Transfers Act (KUFTA). A full discussion of the KUFTA is beyond the scope of this article but in its most basic sense the KUFTA gives creditors a four-year look back period to set aside any transfers that were made with actual intent to hinder, delay, or defraud any creditor of the LLC or its members. See K.S.A. 33-204(a)(1) and K.S.A. 33-209(a). Take as an example members of an LLC who begin receiving demand letters from a supplier for payments the LLC owes for materials purchased on credit. In response to such letters the members of the LLC hastily decide to form a new corporation and transfer the LLC’s only major asset to the corporation. If the supplier eventually sues, not only will it have a good argument to set aside the transfer it will also have a good case for punitive damages against the individual members of the LLC. In, Golconda Srew, Inc. v. West Bottoms, LTD, 894 P.2d 260 (Kan. App. 1995), the Kansas Court of Appeals affirmed a judgment of $10,000 in punitive damages against the individual shareholders of a corporation for making a transfer similar to the example above. The Court noted that the insiders involved in Golconda kept good corporate records and observed all corporate formalities, and it still found the insiders personally liable. See Id. at 268-69. This is just another example that fraud and injustice will always be the dominant factor analyzed by Kansas courts when deciding whether or not to disregard a corporate entity.
You have worked extremely hard to build your business; I can assist you with designing and executing a plan to protect and maximize the value you have created.
John Thompson is a shareholder with Kennedy Berkley Yarnevich & Williamson, Chartered assisting entrepreneurs, families and farmers in the areas of estate and business planning.