Becoming a business owner is rewarding. But you must avoid many common mistakes during the process. If you don’t, your hard work can rapidly unwind and cause nothing but trouble.
In this article, we’ll fill you in on how to avoid common pitfalls when forming an LLC. We’ll cover:
- What legal entity is best for your business and where to form it
- How to ensure your LLC provides legal benefits and functions as you intend
- When to handle things yourself and when you should reach out for professional help
Last updated:
Jan 2023
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Last updated:
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1. Choosing the wrong business structure for your future business plans
What business structure is best for your business? When launching a new venture, you will face countless decisions. Choosing the best business structure is one of the first and most critical choices you’ll make.
The legal structure serves as the foundation for your operations. Selecting the right solution from the start is key.
Common business structures include limited liability companies (LLCs), traditional corporations (C-Corporations), and sole proprietorships. Each comes with specific rules impacting many areas of your business, such as:
- Tax consequences
- Liability protection
- Management and compliance needs
For many small business owners, forming an LLC is an excellent choice. LLCs provide many legal benefits without the tax and compliance burdens corporations face.
LLCs and sole proprietorships receive favorable tax treatment called pass-through taxation. The income flows through to the personal income tax returns of the owners.
Traditional corporations face double taxation. The corporation itself pays income taxes. Then when it distributes the profits to owners, they pay income taxes on the amounts received.
Personal liability protection is another top issue. LLCs and corporate structures receive significant legal protection. If the business gets sued, personal homes, vehicles, and bank accounts are not at risk.
A sole proprietorship does not offer this protection.
Corporations have many compliance and management needs, while sole proprietorships have almost none.
LLCs fall in the middle. The compliance needs are minimal and you have a lot of flexibility in the management of an LLC.
2. Forming an LLC in the wrong state
Which state should you form an LLC in? Each state handles business formation independently. The state and local authorities issue laws, regulations, and other rules LLCs must follow.
It’s common for large corporations to form in business-friendly states like Delaware or Nevada. But small business owners and LLCs shouldn't always follow suit.
Instead, it’s generally best to form an LLC in the state where the business is located.
Most states require LLCs “doing business” in the state to be formed in the state. If they aren't, states usually force businesses to go through a special process to legally operate there. This is normally called a foreign qualification.
For large entities with expansive legal teams, getting foreign qualifications is worthwhile. But for startups operating in one state, this can be an unnecessary burden.
Each state has its definition of what “doing business” means. It often includes things like:
- Maintaining a physical location, such as an office or warehouse, in the state
- Selling goods or services to customers located in the state
- Hiring employees or independent contractors within the state
The consequences of “doing business” in a state without approval can be severe. LLCs can face penalties, be unable to sue in state court, and deal with other serious issues.
3. Not separating personal and business finances
Do you need to open a business bank account? Forming an LLC comes with many benefits. But these advantages can quickly disappear if you don’t take certain steps.
Failing to separate your business and personal finances is one of the worst things LLC owners can do.
The personal liability protection that comes with an LLC is a major perk of forming a legal entity. If your business gets sued or cannot meet its financial obligations, the only assets on the line are those owned by the LLC. Your personal home, vehicles, bank accounts, and other assets are protected.
But courts have the power to remove this protection in some situations. This is known as piercing the corporate veil.
When courts pierce the corporate veil, they can disregard the LLC's legal protections. The owners can become personally liable. Their personal assets can be used to satisfy their creditors. And they might be otherwise held responsible for the LLC’s actions.
For example, using business funds to pay for personal expenses is a quick way to end up in hot water. Including personal spending as tax-deductible business expenses is another common mistake.
To avoid these problems, separate your LLC’s finances from your personal ones. Open a business bank account, use a business credit card, and maintain accurate financial records to protect the LLC’s status.
In general, you must treat your LLC as a separate entity that adheres to corporate governance.
4. Not having a strong operating agreement
Does your LLC need an operating agreement? In some states, LLCs don’t have a choice in the matter. They must have an operating agreement.
Even if one isn’t required, having a well-drafted operating agreement is critical for any LLC.
Operating agreements are private contracts between the LLC members. They establish the way the LLC functions and handles many different situations, including:
- How to add or remove members
- The allocation of profits and losses
- Responsibilities of the members and managers
- The process for dissolving the LLC
Business owners can customize operating agreements to protect their interests. They provide transparency and ensure the LLC operates as intended. The best ones spell out how the LLC will handle nearly any situation it might encounter.
Without an operating agreement, LLC disputes fall back to state law. These can cause unintended consequences that don’t align with your desires.
To protect yourself and your LLC, you want to be proactive. Create an operating agreement when you form the LLC and before operations begin.
It can be uncomfortable to think about potential disputes. But tackling these issues before they happen is best. Operating agreements also help ensure your LLC provides personal liability protection.
The best LLC formation services provide operating agreement templates for as low as $50. This is a great place for many small business owners to start. For more customized help, hiring an experienced attorney can be well worth the extra cost.
5. Skimping on professional advice
Do you need to hire a professional to form an LLC? Forming and running a business is challenging. On top of daily operations, the LLC must follow countless rules coming from many authorities. Understanding them all can be difficult, if not impossible.
This is where professionals come into play.
Attorneys help you navigate red tape related to formation, licensing, and drafting documents. Accountants can help with bookkeeping, taxes, and other administrative tasks.
But professional advice is often expensive. Small business owners can’t waste money on things they can handle themselves. Thankfully, you can get expert advice without burning all your cash.
Specialized services can help with certain LLC needs at a reasonable cost. These include things like:
- LLC formation services
- Professional registered agents
- Automated bookkeeping software
In some cases, you might be able to handle these steps on your own. For example, if you are adept at dealing with bureaucracy, you might be able to form an LLC without help. Or if you have extensive bookkeeping experience, you can consider doing them yourself.
But other times, it is vital to reach out for help.
Missing a legal summons sent to a registered agent can cause a default judgment against your LLC. Making a mistake when forming an LLC can cause serious setbacks, fines, and other penalties. And we all know how serious tax issues can be.
As a new business owner, you will need to carefully select when to handle tasks alone and when to reach out for help. Spending money to get expert advice is a necessary part of running a business.
6. Not complying with state laws and regulations
How do you follow state laws and regulations? Forming an LLC is a major step toward opening the doors to a new business. But it is far from the only one. All businesses have other concerns and ongoing needs to deal with.
Before you conduct operations, you’ll need to get any necessary licenses and permits. Forming an LLC is merely the business structure. Federal, state, city, and county-level officials can require other licenses and permits.
Some local agencies force all businesses to get a general business license, obtain zoning approval, and more. Others only require approval for certain business activities. This can apply to anything from financial services to mobile food vendors.
Complying with tax laws is a paramount concern for every business. Typical LLC tax issues include:
- Getting an employer identification number (EIN) for IRS, banking, or state tax needs
- LLCs that hire employees often need to register as employers and withhold taxes
- If you sell goods or services, the LLC might need to pay local sales or use taxes
Most states require LLCs to have a registered agent. The registered agent receives legal documents and must be available during all business hours. You can fulfill this requirement by serving as your own registered agent, or by hiring a specialized service.
If your LLC fails to file its annual report, it can lose its good standing status and could even be forced to cease operations.
How to Avoid Common Pitfalls when Forming an LLC: Wrap Up
To avoid common pitfalls when forming an LLC, you need to make wise decisions and build a foundation for success. Start by forming your LLC in the right state, typically the place you plan on doing business.
Protect your LLC and all its benefits by using a well-drafted operating agreement. Keep your business and personal finances separate. And handle your regulatory needs with care, at startup and on a recurring basis.
Thankfully, it’s easier than ever to start a new business and get all the help you need. Specialized services and professionals are there to lend a hand.
By taking these steps, you will avoid many common mistakes when forming an LLC. And you’ll be a step closer to transforming your dreams into reality.
