A Common Pitfall in LLCs: Do You Pay Yourself Correctly?
Starting a limited liability corporation (LLC) is a fairly simple way to incorporate a business that is separate from personal affairs, adding legitimacy to many self-started businesses. It is simple, easy, and inexpensive to do. Unfortunately, however, with any “easy” legal process, it can sometimes be over-simplified and operated in a way that opens the door to liability for the proprietor or entrepreneur running the business.
One of the most common reasons to start an LLC, rather than just running your business under your personal name, is to remove some of your personal liability. If someone has an issue with something you do in your business, or your business can’t pay a bill, a creditor or claimant would have to pursue your business – not your personal funds – if you are operating under a legitimate LLC. The key to this, however, is not in merely filing as an LLC with the Secretary of State, which basically requires only a distinguishable business name and someone in the State to serve as a statutory agent. To truly protect yourself with an LLC, the LLC must actually operate as an entity, and not be a sole proprietor just using the name of an LLC. A common mistake is for a new LLC owner to commingle personal funds with business funds.
I recommend one of the first steps of a new LLC is to obtain an Employer Identification Number from the IRS (EIN) and open a bank account. This helps to keep the company’s finances separate from the person’s individual finances, which can be important to show that this is truly a separate entity.
Here are some examples of commingling personal and business funds in a way that could endanger the personal liability protection of an LLC:
Bob Baker started a restaurant and bakery, Bob’s Baked Goods. He opens a bank account in the business’s name. He is excited when he has some profits after the first week of business. His personal credit card payment is due and he really needs the extra funds. He decides to pay for his credit card payment directly out of the bank account for Bob’s Baked Goods.
Kara Kleaner starts a car detailing service. So far, she’s the sole employee of her LLC. When a client pays her in cash, she just pockets the cash to use however she needs to – whether for business or personal.
In these examples, the better approach would be for the owner to either pay themselves as an employee or make an owner’s draw, prior to making the personal purchases or payments. You are allowed to use the business funds, obviously, usually in the form of an owner’s draw if you’re not giving yourself a regular paycheck or salary. However, make sure your company has the cash flow to do so, and make sure you keep track of it in some way, as an owner distribution.
When you start an LLC, however small, it is important to keep track of money coming in and going out. Ideally, you should write yourself checks when you want to spend the money personally, showing that the money transferred from the business to you, the owner, like a paycheck or capital withdrawal before spending it personally. This will help to protect you from personal liability if something goes south.
There is more to this than what a simple blog post can cover, but hopefully, this serves as a good reminder that, if you want the liability protection of an LLC, you must respect the fact that it is a separate entity, and not commingle business and personal expenses or funds.