Top 4 Costly Mistakes To Avoid When Creating Your Business Entity

Michael: Decades.

Toby: Yeah, but you started here in 1999. We’ve been together for over 20 years now. Jiminy Christmas, 24 years? Anyway, a really great lawyer. Today, we’re going to go over the top four screw-ups people make when setting up their business entity.

I don’t want to wait. I want to dive into this, Michael, so I’m going to hand it to you. What are the four top screw-ups that you see? You’ve been doing this a long time, and you deal with this stuff day-in and day-out. What are the four big screw ups you see when people set up a business entity?

Michael: The first thing that you mentioned when I started talking about it and looking at just going back in my past, I’m a recovering litigation attorney. I actually had to deal with it in court when people would make these screw-ups. We got everything from an address, as simple as that. When you go and file on the Secretary of State, what address do you use for the documentation behind it? Selecting the tax status. That’s been a big problem with some of the clients.

Commingling, another huge problem, because obviously, you’re trying to work on the business, and you get a little lazy here. Documentation, not keeping accurate books and records from an accounting standpoint. Multi-dimensional problems with that.

I think the realm that we want to look at is not treating the business like a business in each of the four things that we’re going to be going over. It’s because the individual does not treat the business like a business. I can tell you firsthand, when you’re in the court system, and the judges are looking at it, they’re going to look and see if that business owner, the person running the business, if they treat it like a business.

If the individual didn’t treat it like a business, then why should the court make the plaintiff treat it like a business? The protection that these business entities afford you goes out the window. Bottom line, treat the business like a business. Have respect for it, the courts will have respect for it if you’re going to do a jury, but treat the business like a business.

Toby: All right. I clerked as well. From the bench side, they always say the amount of respect I’ll show is something as the amount of respect you show something. But people are setting up a business for tax benefits, state planning benefits, and raising money for that business purposes. The big one is liability protection.

Liability protection, there are really two sides to it. There’s the liability of the business that is generated. I say I’m a plumber, and I flood somebody’s house, and I get sued in the business. You want to make sure it doesn’t come and take all your personal assets and vice-versa. If I get into a personal car accident because I’m not paying attention, I don’t want them to come and take my business away.

These businesses that we set up instead of a business entity, and you’re usually using corporations, LLCs, Limited Partnerships, things like that, there are all these benefits, and you see people undo it. Let’s focus like a laser beam into the top four that you’ve seen. I know that you said you were coming today with four areas that you see people repeatedly screwing up on. What’s the first area that you see?

Michael: Let’s get into the very basics. The very first thing that you’re going to be doing, you’re going to be going ahead and filing it with the Secretary of State or whatever state you’re doing business. Generally, you’re going to choose the state in which you’re touching and considering citizens of the particular state. Unless you’re not touching, then you can choose a jurisdiction that’s favorable to your business and to yourself.

The first thing is your address that you’re using when you file that initial incorporation paperwork or the formation paperwork for any entity whatsoever. That is the biggest mistake. We get a lot of clients who have already set up a business. They come to us and they say, hey, if I’d done it right, you never want to knock someone down because they did take an initial step.

The first thing I see is that their personal address is listed as their business address. From a legal standpoint, from a practical standpoint, from a personal standpoint, each of them are a little bit at odds with each other. But seeing people use their personal address is so wrong on so many different levels.

Toby: Let’s say I set up a business. Again, let’s just say it’s a plumbing business. I’ll set it up, and you’ll see people that actually put their personal home address. There are two areas that you look at, there’s a registered agent, which every business has to have, and then there’s also the business address. They’ll put their home addresses on both. If there’s a dispute, someone’s going to show up at your house.

Michael: At your house, where you have your family, where you have your neighbors watching. Yes, think how bad that is.

Toby: Yeah, you tick off a client. I always think of this. I have a psychiatrist as one of my clients. He’s like, Toby, I don’t want my name anywhere in the public records. Some of these folks are not well, but oftentimes they’re looking for something. They’re always looking for help. Sometimes it’s drugs, and sometimes it’s something else. They’ll hunt them down. He’s like, I don’t want my name out there.

You see this going on with police officers, by the way. There are a lot of public officials that can have their names out of the public record, and this is why, and then you just undid that by sticking your name and your home address out there for the whole world to see as though it’s a business address. There are all sorts of things.

Michael: Often, they don’t even know any better, they haven’t thought this through, and they haven’t been exposed to it. They’re just doing the best they can. Whenever we see this inside when we review their documents when a new client comes in, it’s tough to see that because of the exposure that they’re from a legal standpoint, but then from like you’re mentioning, the personal standpoint, gosh, it just makes your heart hurt a little bit.

Again, people don’t know what a registered agent is. That’s something I’ve seen in the last three or four years. For a registered agent, you just list it down, it was fine. The courts really latched on to the service of process. I’ll use the case example that unwound this.

If you went back 5, 10, 15 years ago, and the service of process got delivered to a person at your house, let’s say an immigrant grandmother who didn’t speak English, and she took the papers and set them aside, you could go on to the court say, hey, this is what happened. You will be in motion to set aside default judgment, and the courts have granted that.

Toby: Hold up a second, timeout, because I want to make sure everybody understands what you’re talking about. You’re talking about if they serve you, and you never actually get the pleadings because they gave it to a family member at the house.

Michael: It could process its owner. They completed it, yeah. That went away, you never saw it. You could go to the court. The court really at the time wanted to try the cases on the merits. That was […] mishap. But then a case came out where exactly that happened. They listed themselves as a registered agent.

The grandmother or the mother received the papers, put them aside, didn’t know how important it was to it. The court said, no, wait, when you list that registered agent, you are responsible to be business hours available to accept that service of process, you didn’t meet the requirement, we’re not going to do it. That started it, and then it went through all the states like a virus, if you will.

The other thing like you’re mentioning, you’re listing your personal residence there. It’s where you have your family, your home, your neighbors. Don’t do it. Use a commercial registered agent. Keep them away from your personal house and be able to make sure that you get noticed of that lawsuit so you can respond.

Toby: Yeah, let’s interject, too. Also from a business credit standpoint, a lot of lenders are going to look at the address and see if it’s a commercial address. They’re not going to loan to you if it’s a residential address. They don’t loan to individuals under those circumstances.

A lot of them only want to lend to an actual commercial business, especially if you’re looking at non-recourse. You’re just not going to get it. It’s really important that you actually established a separate identity and a separate location for that business. It’s not expensive, just do it.

Michael: I always like to look at it from the legal side, the project side, and generating revenue in the business side of it. I was looking for a service provider. What should I do? I go to Google, put my location in, and see if there’s any service provider in the service I was looking for. I found a few that were in a neighborhood. What does that tell me about the business? That just came way down for me.

Toby: Yeah, it’s not a real business at that point. Again, the amount of respect you show your business is the amount of respect third parties will show it including courts, investors, banks, and everybody.

You want to have your business, treat it with respect. After all, you’re spending your time and energy to put these things together. You set up an entity, you want the benefits of it, don’t screw it up by putting your personal address. That’s number one. What’s the number two screw-up that you see all the time?

Michael: Organizational paperwork, the documents. For a corporation, it’s going to be the bylaws. For an LLC, it’s going to be the operating agreement. That is number one and number two. Generally, they’re messed up together. However, absolutely going to be the organizational documents.

I have a great story that illustrates this. I was speaking at an event in Las Vegas, and this really cute elderly couple came up to me. I was taking a break, and they came up to me and said, Michael, we are so excited because this LLC that you’re talking about, we already have one. I was super excited, because they were excited about what I was sharing with them.

They said, hey, we’ve got it here. Can we go sit, and can you review it for us? I said, absolutely. Let’s go sit down. We set this high top table, and I opened up the first page of it. It was for an LLC, and it says by-laws for ABC LLC, let’s say it’s the company. It’s by-laws for ABC LLC. You’re starting to chuckle, and a lot of laypeople wouldn’t even understand. You chuckled because bylaws are for corporations. This was for an LLC.

I said, okay, you know what? Maybe we could do a little white out and just change it to operating agreement of ABC LLC. After reading through it, it was drafted like by-laws. It made no mentions of the protections of an LLC. My heart is hurting again because they are so excited. How do I let them down easily and tell them what they spent money on is worthless? I got to the end of it and said, shares of ABC LLC. What’s the problem with that?

Toby: You don’t have shares in an LLC, a membership interest. It sounds to me like they went and they did probably something online, or boilerplate.

Michael: Unfortunately, they went to an attorney, and the attorney charged them about $2800 to get this done.

Toby: An attorney did that?

Michael: An attorney did that. We talked about it. Here’s where it comes into. The charging order protection applies to LLCs, and that’s what they wanted. They wanted the protection for the asset against any liability from themselves. I explained to them, and we were able to help them out by getting a good set of documents.

Again, what the court’s going to say is, if it walks like a duck, if it quacks like a duck, it’s a duck. This is a corporation. If the plaintiff attorney came after it, I’d have it treated as a corporation under the RMBCA (Revised Model Business Corporation Act), knowing that the opposing counsel probably had no idea why I was doing that. The main thing is if I get treated like a corporation, that charging order does not apply.

The documentation matters. Plus, when we look at a business entity, when we look at the documents, whether it’s by-laws, or we look at it from the operating agreement standpoint, a lot of people look at those as restrictions. No, they’re actually privileges. We have different abilities to take medical care reimbursements. It’s all privileges and benefits that those documents give us.

It also comes back to, if we ever go into court, if you come in with just a folder full of papers, and you’ve thrown them down, you don’t look that professional. You’re not treating that business like a business, and then the court isn’t going to treat it also.

It also goes on audits, too. I’ve talked to many auditors who know about this stuff. I said, if we come in and we see a well-organized set of documents, we might look at a few things, but we’re out of there. The reason why is that we know that those Is are dotted and the Ts were crossed, not a good place for us to spend our time where we’re going to go somewhere, where they’ve got just, again, a couple of pieces of paper together to show their business in a shoebox full of receipts.

Toby: If you’re banking, or if you’re trying to get a loan, and your documents don’t look the way that they want to see them, you’re done. You’re just going to get—.

Michael: The presentation, right?

Toby: Yes. We always say it’s the interpretation of the presentation. If your presentation sucks, don’t expect to get the result that you want. You just undid it again. You said this nice couple, somebody is trying, they’re doing what they can, and they’re undoing all the benefits of what they’re setting up, because they make these big mistakes.

All right, that was number two. Let’s dive into number three. What’s the third area that you’re seeing people screw up when they’re setting up a business entity?

Michael: It’s commingling and not separating personal from business. That starts from the very beginning. It’s bad in a couple of ways. Again, we’re getting back to treating the business like a business, when you start using business dollars on personal benefit or personal dollars on business benefit.

I was involved in many cases where the first thing that I would do is get a forensic accountant to go through the records and show every single time that that individual disrespected that clear separation between the business and themselves. Why? Because then I could move the court to go ahead. If the business owner didn’t respect that separation, why should my client?

Toby: Even with money, a lot of times people will use the bank account interchangeably for their own, those start buying everything for themselves, their business, and they go, it’s a write-off. No, it’s not. It has to be, you have a profit motive. When you’re expending that, there has to be some reason it’s being used for business sense, because you’re going out buying your groceries.

If you’re buying your groceries, you’re just thumbing your nose at this thing saying, hahaha, I’m so cute. Don’t expect a court to fall for that, don’t expect the IRS to fall for it, and don’t expect an investor or a bank to be party to that.

They’re going to look at that and go, this is the earmarks of somebody who does not know how to run a business. It’s not a business, it’s a personal piggy bank that someone’s just messing with, and we’re not going to honor it by giving it any of our business.

Michael: What we’re seeing here a lot of is the formalization of an entity or treating it with respect. Not only translates to great protection and liability protection for the business from you and you from the business, but we’re also seeing a crossover from an IRS standpoint, an audit standpoint. That would even lead into our next topic.

Toby: We got four. This is the fourth one, Michael. We’ve got four screw-ups.

Michael: Four screw-ups, and these are so common. Again, the attorneys here at Anderson deal with this every day, because I want to talk to them and pull them. It’s good bookkeeping and records, making sure you have a good set of books.

Toby: Books and records. Who would have thunk it? Here’s my pet peeve, and I know you’re going to dive into this. My pet peeve is, you always see these folks saying, oh, the formalities of a corporation are so much higher. They have to keep books and records.

I’m like, every business entity, whether you’re a sole proprietor, a partnership, an S-corp, a C-corp, LLC taxed as an S-corp, LLC taxed a C-corp. It does not matter what you are. You have the same books and records requirement. You have to keep a paper trail of what your expenditures are, and they screw it up all the time.

Michael: Your pet peeve is my pet peeve, because it’s such a fallacy. I was actually wanting to start a business anyway, I was quite young, in 2019, 2020, 2021 right there. Even my father said, hey, you know what? It’s too many corporate formalities. I had it in my head that oh, my gosh, it’s too much work. I got to do an annual report, I got to do an annual meeting, I got to have all these meetings. All of a sudden, one of my buddies started his own business. I said, well, if that bozo can do it, so can I.

I started realizing these meetings are actually more beneficial to me than a burden on me, because now all of a sudden, I’ve got historical records of where I wanted to go. Did I get there? It held me accountable, but also I had a better finger on my financial pulse, because now I got a clean set of books. Instead of a shoebox full of receipts that I would just hand off on April 14th to my accountant, now I can actually keep a finger on the financial pulse.

I can look at my activities, and I can say, okay, this was generating profits. Okay, this activity over here is actually a drain and a deterrent from the actual profit centers that I had there. Whether you’re a business owner, a real estate investor, or a stock trader, you can look at your activities and have a better finger on the pulse of each activity because it’s all separated out. If you aren’t generating the profits that you want, you can go ahead and make adaptations because you understand where you’re at on each of those levels.

Bookkeeping is something that I have a love-hate relationship with. I remember my first time working with QuickBooks, I was putting numbers in, and it should have been decreasing columns, it was increasing columns.

Once I got that down and actually employed a company to actually do my bookkeeping, I really felt I was more in tune with my business. I was able to jettison some of those activities. I was emotionally attached as I was to them. I was able to just set them off. Overall, it was better for the health of the business.

Toby: If you want to have a separate business, remove yourself. If you were removed from the equation, what is left? What is the story that the records tell? That will tell you how valuable your business is.

Michael: You’re not even able to do that, because you’re so emotionally involved in it at times, too.

Toby: When a bank is sitting there looking at underwriting a loan, they need to see the paper trail. They’re not going to sit there and be talking to you. That doesn’t paper their file. That does not do what they need to do to justify a loan. Or if you’re raising money from an angel investor, or you’re pitching and trying to get new investors, it’s not enough to say, oh, I told somebody. You have to document these things.

I think what is really hitting here is that when you do not separate that business out from yourself, the default is it’s you. If it’s you, lenders don’t want to deal with it. Courts are not going to honor the separateness. Banks are not going to honor the separateness, and you’re going to end up being not taken as seriously as you should be if you’re a traditional business, and it’ll cost you in the long run.

You just nailed four areas. I just want to go over them really quickly. Again, I think you’re using your personal address, you’re not creating a separate commercial…

Michael: Don’t be our own RA and don’t have your corporate address. Absolutely.

Toby: Two of those. You have the registered agent required for the entity, and you have a physical address for the business. You have to make sure that those are commercial, especially for lending. They won’t loan to a residential in many cases if it’s a true commercial. There’s that one, which is using your personal address. Don’t do that. Number two, I believe, was the…

Michael: Yeah, the documents, documents, documents. There’s something else I want to add in, your resolutions, your consent to actions, things like that. Again, these things are all—

Toby: That’s in the books and records. That was number three, right? You have books and records. No, commingle was three, and then books and records was number four. Bad docs, using your personal address, commingling assets, and books and records, not having good books and records. I think you nailed it.

Michael: There are so many more. I think I have about 20 when I started brainstorming on this. Again, Anderson, one of the best successes we have is watching clients grow, grow, grow, grow and become successful. The next step is forming a nonprofit and start sharing that wealth. There’s no reason that these court formalities should be looked at as a burden. They should be looked at as a benefit.

We want the business to succeed. It’s been so fun, over the last couple of decades, to watch businesses grow, still chat with those clients, and reminisce about when they had one little business or when they had one investment property. Now they’ve got hundreds of doors.

We just want everyone to be successful. It’s not that hard. You just have to pay attention to it. Treat the business like a business, and you’ll reap the benefits of it.

Toby: Perfect. Thanks for joining us, Michael. I’ll put your information down below. They can always go to Anderson Advisors to find you, one of the partners here. You can always reach out and contact him and say, hey, I’m worried about my business, will you take a look at it? Or better yet, hey, I’m thinking of setting up a business, make sure you do it right.

Michael: Correct. I wish everyone the best of success. Appreciate everyone.