If you are out there doing real estate deals, whether they be Fix/Flip, Buy/Hold, or Wholesaling transactions, hopefully you have a corporate entity in place that suits your needs rather than conducting business or taking the title in your own name. There are important benefits to using an LLC as a legal structure for your business.
What is an LLC?
A Limited Liability Company (LLC) is a formal registration of a company with the Secretary of State department (usually) within the state the company is located. The LLC serves as an official entity that legally separates a business and its owner(s). Once an LLC is formed, all contracts and (most) legal liability is then associated with the LLC directly, as opposed to the owner(s).
Conversely, in partnerships and sole proprietorships the owners remain personally responsible for all legal liability which can include personal property. That means that if a business claim against you goes the wrong way, you could lose your personal house and belongings.
Some folks may recommend that you register your business in Delaware or Nevada, but I have found that generally the best (and easiest) practice is to register it in the state that you are primarily doing business in. If you have a physical presence in another state, or do business across states, you will have to register a foreign LLC in each of them.
If you plan on having a fairly complicated business model that spans multiple states, I recommend that you consult with your real estate attorney before setting up your corporate structures. Most of the investors we know operate in just one or two states, in which case the registration process is fairly easy.
4 key reasons why you should use an LLC
This isn’t the first thing people think about when contemplating whether to get an LLC, but I think it’s an important one. Having an LLC makes you look more ‘official’, whether you are dealing with a lender, a supplier, a prospective contractor, etc. It gives the impression that there is a business and structure in place around you, which hopefully is exactly the case.
How do you react when you meet someone who hands you a business card with their name and company info/logo on it, as opposed to someone who hands you a card with just their personal name on it? It doesn’t mean that one person is any more or less capable than the other, but it does give the impression that the person with the LLC and logo is more businesslike and has, if nothing else, taken the initiative to set up their business.
You work hard to build up personal wealth, including your home, vehicles, savings accounts, and other personal assets. Without proper protection, one mistake in your business could jeopardize all of that, if you don’t have an appropriate legal structure in place for your business. When properly formed and operated, the LLC can form a separation between your business and your personal property, which is the first shield of protection.
If an incident were to happen in your business dealings, where someone feels they were damaged and wants to initiate a lawsuit, in most cases they could only successfully sue your LLC, and not reach you personally (this is also called the corporate veil doctrine). If you have set up and run your LLC properly, it is very difficult for a plaintiff to ‘pierce the corporate veil’ and come after you personally.
Corporate shield laws vary by state to state, but this is a huge reason why your attorney would also insist that you operate your business under the protection of a corporate entity. Click here for more info from Intuit QuickBooks on piercing the corporate veil.
Flexibility of Taxation
LLCs provide flexibility on how you want to be taxed – as a partnership, C Corp, S Corp, or a sole proprietor. There can be advantages to each, so check with your tax advisor to see which way might suit you best. Many tax advisors point toward being taxed as an S Corp due to its savings on self-employment taxes. However, once your business is really doing well and you exceed certain income thresholds, the self-employment tax benefit disappears, and this may not be the best financial option for you.
If you are the only owner of the LLC (or if you file taxes jointly with your spouse and the two of you are the only owners), then the IRS will treat your LLC as a disregarded or pass-through entity, meaning that you don’t need to file a separate tax return for the LLC. If you have multiple partners in your LLC, then you need to file a return for the LLC and issue Form K-1s to each owner for their shares of income or losses.
Ease of Operating
In order for an entity to provide the protection and benefits available to you, it must be operated in the proper manner, and not neglected. One of the reasons I strongly prefer an LLC for real estate investors (over say an S Corp), is the relative ease of operating requirements needed to keep the organization in good standing.
Some types of entities require the owner(s) to have frequent Board Meetings and document each meeting in writing, whereas the LLC is typically much easier to maintain and operate. I like the comfort in knowing that I can keep the corporate shield up without formally documented Board meetings & minutes.
How to Set up an LLC to Handle Multiple Assets
Suppose that you have, or intend to acquire multiple assets. Some attorneys recommend that you should have a separate LLC for every deal you do. Should you?
Well, that depends on your risk tolerance, as well as how much equity you have in the properties. Should a claim be filed against you, you don’t want to have all of your net worth tied up in the LLC where aggressive opposing attorneys could get to it. If you have maintained your LLC properly, and haven’t committed fraud, then the accusers likely won’t be able to pierce the corporate veil and get more than the assets that you have in the LLC.
Let’s explore the concept of multiple LLCs for multiple properties, using scenarios involving investor models of:
- Fix and Flip;
- Buy and Hold; and
- Joint Venture partnering with others
For instance, if you Fix and Flip properties one at a time, then one LLC would likely protect you just fine. You buy a property, remodel it, and sell it, using the sales proceeds to purchase your next property. Under this model, you only own one property at any point in time, so your financial exposure is likely reasonably contained.
Still, if your projects tend to be very large, complex, or risky, then it may be prudent to have a separate LLC for each project, even though your ownership of the properties doesn’t overlap (note that your liability doesn’t go away when you sell the property, so that area would overlap multiple projects).
If you are a Buy & Hold investor, and have significant equity in a given property, you may be well justified in obtaining an LLC just for that property. I have heard of investors doing the “100k test”, whereas if any individual asset has $100,000 or more in equity (market value less debt), then they place that asset in its own LLC. Depending on your financial posture and your risk tolerance, this 100k dollar amount threshold test could swing up or down considerably.
Another good reason to have a separate LLC for a specific asset is when you have Other Partners investing in the property with you. This applies regardless of whether you are operating a Fix/Flip or a Buy/Hold model. Let’s say you own 3 properties and each is leveraged with debt, such that they each have just $10,000 of equity in them.
Your LLC owns 100% of two of them, but the third property is owned jointly with a friend or is subject to a joint venture (JV) agreement. It may be wise (especially from your friend’s perspective) to put that third property in its own LLC, even though none of the properties are loaded with equity.
The reason for this is as follows: What if a tenant sues you, regarding one of the properties which you own 100% of? Well, if they were to prevail and get a settlement award or judgment of say $50,000, that would be enough to burn through the equity you have in all 3 properties, including the one that your friend has an interest in. Is it fair for him to get dragged into a legal action that has nothing to do with his property, other than having common ownership with your other 2 properties?
This concept of one property poisoning the others is why you will hear attorneys and investors talk of separate LLCs to protect separate interests of the owners, even if the equity in the property is not overly large. In this manner, separate LLCs ‘insulate’ one property or set of properties from others, offering greater protection.
What to Do After You Have Your LLC in Place
Whether you already have an LLC in place, or are now convinced you need one, there are important next steps, such as selecting the right name, setting it up properly, and operating and maintaining it in a manner that preserves the benefits you are seeking. We will address those areas and more in an upcoming article.
Disclaimer: Please note that I am not an attorney, nor am I trying to give legal advice. Prospective business owners should consult a legal professional before forming real estate entities.
Forming Your LLC
Making sure you set up an LLC correctly, and – just as important – taking the steps to maintain it, is crucial as making the decision to establish your LLC. To this end, we will also illustrate what to do and what NOT to do in terms of keeping your protective shield up. Let’s start with how to form your LLC.
Be sure to check with your legal and tax professionals to determine the best corporate and tax structures for your business. Here is a handy checklist to use when looking to form your LLC; we then explore each step below:
- Select the State(s) that you want to Register in.
- Pick a Name for your Business.
- Self-Audit & Cross-Check your preferred Business Name.
- Register your LLC.
- Obtain a Federal EIN.
- Open your Bank Account, & Implement an Accounting System.
1. Select the State(s) That You Want to Register in
It is typically easier, faster, and cheaper to set up your LLC in the state where you and your business primarily reside. You have probably heard of people forming LLCs in states that they don’t actively do business in, such as Nevada and Delaware, because of their business-friendly environment, tax benefits, and/or privacy (anonymity). Add Wyoming to that list in recent years, as they have a growing reputation in these areas as well.
But unless you live in one of those states, or if your attorney or tax accountant has identified some specific reason for your business or industry, it is likely most efficient to just register in your primary state of business. If you set up a company in one state, but you live elsewhere and are conducting business activity in your home state (or any other state), then you will likely also need to register as a foreign LLC in those states. In this area, ‘foreign’ refers not to another country, but to a state where business is being transacted, that is not the state where the LLC is registered in. In contrast, if an LLC is registered in a state and conducts business in that state, the subject state would consider that company a domestic LLC.
For instance, let’s say you live in Arizona and do business in Arizona and California, but want to set up a Wyoming company because it has no business income tax and allows for lifetime proxies, which means the legal owner can appoint someone else to represent the shares and to vote, giving that legal owner full anonymity/privacy. You would register in Wyoming, and then likely also register in Arizona and California as foreign LLCs, paying the registration fees in each state. Even though you live in Arizona and do business in Arizona, the state of Arizona will expect you to file there as a foreign LLC.
So while you may avoid paying income taxes in Wyoming, you would still be required to pay income taxes in Arizona, as a foreign LLC there. Don’t be fooled by salespeople trying to sell you on setting up LLCs in Nevada, Delaware, or Wyoming with the main purpose of avoiding income taxes on properties located in other states. You will still need to do a foreign LLC filing in those states, which negates the tax benefits being touted by those states. Here is an informative video from Clint Coons, Esq. regarding the pitfalls of incorporating in NV, DE, or WY if your assets are in other states.
This is not a one-size-fits-all area; consult with your tax and legal professionals to determine your best entity formation strategy, so that you don’t get stuck with extra fees to those states, without much protection to show for it. Here are some additional items to consider if you file in Nevada, Delaware, or Wyoming but then need to register foreign LLCs:
- by having to register as a foreign LLC in the actual states you are doing business in, this adds cost and typically negates the benefit of the registration state not charging income taxes (because you will still be required to pay them to the foreign state).
- the registration forms that most states have for foreign LLC are different than that of domestic ones.
- the registration fees that states charge to foreign LLCs are usually higher than they charge for domestic LLCs.
- if you set up an LLC in a state where you don’t reside, you will need to pay a registered agent to accept process of service and to represent you in that state.
- perhaps most importantly, if you don’t register in a state where you are doing business, you may be subject to penalties and fees, and may also have difficulty defending yourself in the court system there should you be sued.
For the above reasons, it is typically easier to set up your LLC in the state where you live, especially if most/all of your business activity is also there. You are likely to be more familiar with the business laws there, as well as enjoying proximity to the governmental offices if needed. For more about the advantages and disadvantages of setting up an LLC in a ‘business-friendly’ state that you don’t reside and do business in, see this LegalZoom article.
2. Pick a Name for Your Business
You may already have a name for your business. If you do, you might be all set with this step. But please still take a look through the checklist below and see if your current business name hits the mark on most of these items. The best time to create or change your business name is BEFORE you take the time and expense to register it with one or more states.
- Does your name meet at least several of these attributes: memorable, descriptive, creative, catchy, unique but not too unique, inspirational?
- Does your name make sense to your target customers? (after all, that’s who you’re trying to reach)
- Is it congruent with your core values or goals? (my investor-facing company is True Freedom Achievers, LLC, which I intended to be descriptive, easy to abbreviate as TFA, inspirational, and in keeping with my goals of freedom and constant achievement)
- Is it too restrictive? (Ideally you want it descriptive without painting your business into a corner, such as Jim’s Phoenix Remodels)
- Does it fit with your competitive analysis? (not too similar to competitors yet not too unique)
- Is your business name short enough to avoid too many keystrokes? (“Really Cool and Contemporary Custom Designed Homes” gets the point across, but who wants to type that into a search engine, and would they remember the acronym RCCCDH?)
- Does it have an unintended or alternative meaning? (such as the Chevy Nova car, which loosely means Chevy ‘no-go’ car, in Spanish)
- Have you checked to ensure the name isn’t already under trademark or copyright by someone else?
- How will your name present and perform on social media platforms?
- Does the name have ‘staying power’? (will it likely pass the test of time and still have relevancy 5 or 10 years from now?)
3. Self-Audit & Cross-Check Your Preferred Business Name
Once you have selected a name that you are confident in, you will want to cross-check it against several databases to ensure that it is available in these key areas:
- Is the business name already taken in the State(s) that you want to register? This is the biggest reason that registrations get denied, so do your homework ahead of time. For Arizona, here is the link to the entity search box of the Arizona Corporation Commission; type in your proposed name and see if it is already taken by someone else. Once you register the name, it will generally offer you protection against others who might try to use the same name in the state.
- Is the Domain name available? You’ll want to secure and protect your online presence, so use an accredited domain registrar to check for availability and secure your domain. There are literally hundreds of accredited ICANN registrars, which you can view by clicking on the link, or do what I do and just use GoDaddy.com. If your full business name isn’t available, it’s not ideal but don’t fret it; your domain name doesn’t have to match your entity name. Also, I strongly prefer .com names, but I’ve seen plenty of folks in the real estate space go with other extensions like .co or .biz when the perfect .com domain is not available.
- Is the Trademark available? Once you have cleared your business name with the States that you will be operating in, and with the Domain Registrar of choice, your prospects are good that you will prevail in obtaining successful registrations of those areas, which will give you some protection within those states, and over the internet. You can opt to take it one step further by applying for a trademark for your new business name and/or logo. While not required, this would provide additional protection against would-be infringements by others in the same or similar industries. In the U.S., trademarks are registered and maintained through the United States Patent and Trademark Office; you can search the database at the preceding link.
4. Register your LLC
Now you are ready to register your LLC. The registration process varies by state, so do an internet search for your state’s DOS (Dept. of State) or SOS (Secretary of State) to find the exact procedure. In most states, in addition to paying the fees (which vary from about $50 to $500 depending on the state) and completing the application, you will also need to prepare the following documents:
- Articles of Incorporation (simple formatted info that is specific to each state);
- Operating Agreement (required by some states and a very good idea to have, as this is where you document who your members are, who will handle tax matters, how equity and profits will be distributed, and generally how the company is to be run, particularly if the unforeseen happens).
You can usually register the LLC on your own, by following the specific requirements of your state. Or, for a fee, you can use a paralegal service company to handle the registration process for you.
Sometimes, in addition to the registration fee, there is also a publishing fee. In Arizona, for instance, there have been publishing fees for years, but in 2017 the publishing requirement was eliminated in Maricopa (Phoenix metro) and Pima (Tucson) counties. Some other notable AZ counties still have the publishing fees, including Yavapai (Prescott) for ~$50, Pinal (Casa Grande) for ~$45-50 and Coconino (Flagstaff) for ~$85-90.
For my Arizona LLCs, I use Mary Carlton at Valley Documents, a paralegal who does a great job on the whole registration process, for around $200 for my Phoenix-based companies. That price includes the fee for the AZ Corporation Commission filing, the Articles of Incorporation and a standard template that you can use for the Operating Agreement, along with the fee for publishing the entity information if required by the county. To me, her one-stop price for the service is very reasonable. Add her to your power team if you’re doing business in AZ – she can be reached at 480.231.1752 (cell) email@example.com (email), and her website is www.valleydocs.net.
5. Obtain a Federal EIN
Once your new LLC has been approved by the state(s), you will want to get a FEIN. This will be a requirement for your banker to be able to open a business account for your new company. The process is relatively quick and easy, especially if you apply online. Go to irs.gov and search on “FEIN” to see options for applying online (almost instant results), by fax, or by mail (by far the slowest mode).
6. Open your Bank Account, and Implement an Accounting System
Bring your FEIN approval to your local bank or credit union, and open up your new bank account(s) for your business. I recommend that you open at least one checking account (as the primary vehicle for your transactions) and one savings account (which you can use to park funds that will be needed in the future, such as for paying income taxes or upcoming payrolls).
Now that your business is registered and your bank accounts are set up, you are literally “in business!” And you need to respect your business entity and run it in a professional manner — starting with an accounting system and controls to ensure that you don’t unwittingly compromise the protection that you just created for your business. We use Intuit’s QuickBooks Online, which can be tailored for Fix and Flip projects, as well as other real estate activities.
What’s important here is that you set up systems to account for all of your business’ transactions on a timely basis, looking for irregularities or items that could endanger the protection that your new LLC is trying to provide to you. More about that in the next section on Maintaining your LLC.
Final Thoughts on Forming your LLC
Creating the right corporate and tax structure for your business goes hand in hand with having a solid business plan to execute against. Don’t take this process lightly, and seek help from professionals along the way. There is also lots of good information available about launching a business on the Small Business Administration’s website.
Maintaining your LLC
Protecting your personal property is one of the most important reasons for forming an LLC. This protection is accomplished by separating your personal property from your business property. When the LLC is properly operated and maintained, it becomes very difficult for a plaintiff to ‘pierce the corporate veil’ in a lawsuit. To preserve this protection, there are some key items that need to be followed:
Ensure that the Operating Agreement is being upheld and not violated, & that the LLC is always held out as a separate legal entity.
Keep the LLC in good standing. Pay all taxes on time, ensure your LLC registration & any ongoing fees are paid on time.
Don’t co-mingle your personal and business funds. Have a separate bank account for your LLC and pay all business expenses from that account, and all personal expenses from your personal accounts. In the rare instances that you may need to pay a business expense from a personal account, you should immediately reimburse it and document it clearly in your accounting system.
An example of this could be when you need to pay your LLC registration fees in advance of receiving LLC approval, and therefore before your FEIN and business accounts are in place. Usually, your only choice is to pay these initial business start-up expenses via another bank account. In this instance, you should advance the funds from that other account, and once the new entity is set up and funded, the advance should be promptly reimbursed and documented. If there is frequent co-mingling of the accounts, it provides fuel to an opposing attorney that you are not operating your entity as a separate business, so you shouldn’t be afforded the protections of a properly run business.
Similarly, do not use the LLC’s assets solely for personal use. Rather, make sure there is a valid business use as well.
The members of the LLC must act responsibly, and if they commit fraud or are personally negligent, the protection of the LLC can vanish for them.
Simply put, while states vary on what tests they use to determine if the corporate veil can be pierced, if you want the protection & benefits that the LLC is designed to give you, in return you must treat the LLC as a separately operating and responsible organization.
Disclaimer: Please note that I am not an attorney, nor am I trying to give legal advice. Everyone’s situation is different. Prospective business owners should consult legal and/or tax professionals.