We have to balance finding the flaws with the building with not destroying a house our client has no equitable interest in.If there was a problem with an inspection and it was something evident and apparent, then Inspectors hold liability and can be sued.  

I don't think an LLC is specifically required by law, but it would be probably a best practice.An LLC is a limited liability company.

Right now they don't officially "know" about any contamination issue, if you give them test results, they may feel they have some liability for not disclosing. 

Learn how to make a PERSONAL FINANCIAL STATEMENT (Assets and Liability statement, Income & Expense, Cashflow) or have a CPA make one for you and show it to your lender.

No offense but I assume you don't have any loss prevention training or experience, and I assume you won't want to take on liability if something in my house does go missing while you show it. 

An LLC is a business entity that is used to limit liability, hence Limited Liability Company.

At first we thought to start an LLC after our first flip, but after looking into tax preparation and personal liability, it seems to make more sense to set up the LLC before the first flip.

How to avoid issues with company mishandling of funds ( liability ) ?

I recommend having LLC and larger liability insurance as you don't know how much the LLC would protect you from the lawsuit.  

Less risk, more diversification, same returns, and much much less exposure to liability.