Darius M. Barazandeh | Free Newsletter

5 Mistakes That Can Threaten Your Liability Protection – And How to Avoid Them

Tuesday, April 22nd, 2008

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. Get the details here.]

Rating: 0 (from 0 votes)

Posted in Entrepreneurship, Wealthy | No Comments »

Why You Should Be Concerned About Liability Protection

Tuesday, February 26th, 2008

One of the best ways to create massive, passive income is to invest in real estate. Even today, when real estate is in trouble in much of the country, you can still make a steady living as a real estate investor. But before you jump in, remember that – as with any business – you’ll want to set up your real estate business in way that not only maximizes your financial reward but also minimizes your risk.

Real estate requires you to deal with tenants, sellers, partners, investors, lenders, management companies, independent contractors, employees, and others. The more parties you deal with, the more likely it is that something may not go as planned.

The first step to protecting yourself is to learn how to run your business in a fair and careful manner, so you reduce the chances of getting sued. But it’s also essential to protect your personal assets by doing business as a corporation, limited liability company (LLC), or limited partnership.

Each of these structures creates a special legal relationship between the business owner(s) and the state and federal government. The idea behind them is to promote commerce by limiting an owner’s liability to the amount of money he invests in his business – and, thus, limiting his risk. And they have been around for centuries, some pre-dating the founding of this country.

In England during the colonial period, creating a corporation required a grant from the King or the Queen. It’s easier to form a corporation today, but it’s good to remember that this liability protection is still a privilege.

A corporation, LLC, or limited partnership is not an excuse to act in a careless or negligent manner. You need to be fair when dealing with all parties. You need to outline agreements with partners, vendors, contractors, etc. And you need to respond to tenants’ complaints.

These are good business practices – what I call Lawsuit Avoidance 101, because they reduce your risk of getting sued.

But keep in mind that in your dealings with tenants, sellers, partners, investors, lenders, management companies, independent contractors, etc., you may occasionally need to take someone to court because your rights have been violated, a contract has been broken, or money has not been paid to you.

And that’s where the protection of doing business as a corporate entity comes in.

When you assert your rights, it’s not uncommon to be sued in return by the other party. This is called a cross claim. Usually it happens because the other party’s attorney believes they have a claim or will be in a better position by using a cross claim – and it could put every asset available to your company at risk. But with the protection of a corporation, LLC, or limited partnership, your potential personal losses are limited to your investment in the business. Without that protection, you could lose your home, your car, your retirement savings, and anything else of value that you own.

So which of these business structures is right for you? Your individual situation will determine what works best, so be sure to consult with legal and financial advisors before you make a decision. But most real estate investors tend to fall into one of two categories:

Short-term buyers and sellers ("flippers")
Long-term investors in rental properties – what I call "buy-and-hold" investors

Short-term buyers and sellers will benefit most from an LLC taxed under Subchapter S of the IRS tax code. This structure allows you to minimize the self-employment taxes you’ll owe from active income (such as buying and selling properties) by re-classifying some of it as passive distributions that are taxed at a lower rate. Both a corporation and an LLC will protect you personally from business liabilities, but the LLC can protect your business from your personal liabilities as well.

Long-term buy-and-hold investors make most of their money from passive income (such as rents), so the self-employment tax isn’t as much of a burden. For them, a Subchapter K LLC usually has the most tax benefits. The primary benefit here is that many real estate investors borrow money to purchase rental property. The savvy investor wants to ensure that any debt or remaining balance owed on the property can be used to reduce other reportable income earned outside of the business. The S election does not allow this.

A business that operates under Subchapter K can usually choose between an LLC and a limited partnership. The LLC is simpler to run, cheaper, and costs less to set up.

Many new investors balk at the time and expense of setting up a corporate entity, but over the long term, the costs of not doing it are usually much higher. A properly structured business faces far less risk of an IRS audit, protects your personal assets, and can dramatically reduce your annual taxes. You owe it to yourself and your investing business to use these entities to your best advantage.

Rating: 0 (from 0 votes)

Posted in Real Estate Investing, Wealthy | No Comments »

Darius M. Barazandeh's Newsletters

5 Mistakes That Can Threaten Your Liability Protection – And How to Avoid Them

Why You Should Be Concerned About Liability Protection

Sign Up for our Free Newsletter

Main Menu

Newsletters