The correct use of entities in a real estate investment business is one of the most common mistakes I see investors make. A Sole Shareholder Limited Liability Company or SMLLC, being the most common. In the states where we work, we are fortunate to have the opportunity to use SMLLC because not all states allow it. An SMLLC is a single-member LLC, and there are pros and cons with this structure, as described below.
Before I go too far, I must say that I am not a lawyer and do not practice law. I am simply sharing my experience and what I have learned from attorneys and judges throughout my career as a real estate investor and hard money lender.
As a hard money lender, I see a lot of business structures. Chartered accountants love these and put a lot of pressure on them. The reason for this is that SMLLCs are extremely easy to set up, are forgiving if you don’t maintain them, and don’t require a separate tax return. All income and expenses in an SMLLC will flow directly into the member’s personal tax return without the need to file a return for the company. This is a great tax advantage and avoids the cost and time of filing a separate tax return. The problem with this is that while it is great for public accountants, it may not be the best entity for asset protection. And what other reason would an LLC have if it weren’t trying to protect its assets?
The SMLLC has some major difficulties. Because they are easy to set up and run, many LLC owners will not do anything with the business. This could allow a plaintiff in a lawsuit to penetrate the LLC, leaving no protection for the owner. The two most common examples of this include, the member who does not have an Operating Agreement and the combination of funds. It sounds funny, but yes, you must establish a written agreement on how your LLC will operate. This includes disclosing authorized owners, managers and decision makers. Of course, it will be all of these, but you need to put it in writing and sign it. Yes, you must agree with yourself. The Operating Agreement is the statute of the company and, without it, you do not have a legitimate company. The combination of funds is very common and would indicate to the court that you are not operating the LLC as a business. If you are not operating as a business, you are not a business and you will not offer the protections of a business. The best way to get money in and out of an LLC is to transfer money to and from your personal account and enter these transactions on the company’s books as contributions or distributions from the owner. Once the money is in your personal account, you can spend it however you want. If you spend the money directly from the LLC account without first transferring it to a personal account, you might consider mixing personal money with business money. You’d be surprised how many of our customers shop at the grocery store or at Starbucks or Redbox from their business account. These are obvious red flags that the owner is not running a business separate from them.
Another disadvantage of an SMLLC is the lack of protection against external demands. Let’s say you own a rental property in an SMLLC and someone slips and falls because the sidewalk was icy. That could create a lawsuit within the LLC. In this example, assuming you run the LLC correctly, your assets outside of the LLC will be safe. The challenge arises if you are sued personally, as if you were in a car accident. In that case, all 50 states will allow the creditor to obtain a collection order giving them rights to the LLC’s distributions. A collection order would award the creditor any distribution the LLC makes to that member. You can protect the LLC from a charge order by not making distributions. In most states, this collection order rule is reserved for SMLLCs, and the creditor can force a distribution to a single member. The charge order rules are there to protect the other partners or members of a group. Most states view the SMLLC as an asset that is 100% owned by the member and there is no need to restrict a creditor because there are no other members to protect. The advantage of the collection order for multi-member LLCs is that it protects all other members from the personal liability of any one member. There are three states that I know of that will prevent a forced distribution with a charge order at an SMLLC, which is why you hear some gurus say that you should establish your business in Delaware or Nevada. While these states do offer some additional protection to SMLLCs, you do need to file an application each year in your state. That could include paying for a registered agent in that state AND you will need to file the foreign entity in the state where you want to do business. This costs more money and leaves additional room for error by not operating the business properly. Creating a multi-member LLC, even if it is a close friend or spouse with a minority interest, will offer the same or even better protection against collection of orders. States govern LLCs, so it is important to check state laws when deciding which entity to use and where to file that entity. It is important that you speak with competent legal advice about your situation and the rules of your state LLC before making a decision.
I’m not saying you should never consider an SMLLC. In fact, leave the opposite. If you are just starting out and don’t have many assets to protect, it is probably wise to use an entity that is easier and cheaper. An SMLLC is extremely easy, making it a great starting point. One benefit of an SMLLC is that it allows you to obtain a separate tax identification number, which is important when you need to submit tax forms to vendors. You don’t want to give your personal social security number to everyone you do business with, so I would say that using an LLC and not doing business on your personal behalf is smart. An LLC is extremely flexible, as your LLC earns more assets, you can always add a second member or even change the way you are taxed. No matter how you decide to structure your entity, it is highly recommended that you operate it correctly.