I see it several times per day, everyday: An LLC disaster waiting to happen! No matter where I travel or with whom I speak, it’s clear that small to mid-sized business owners are not getting proper instruction on how to create, run, and maintain a ‘rock solid’ LLC. Did you or your attorney form your LLC? Are you now left with a stack of papers and confusion?

One comment that I repeatedly hear is, “Well, my attorney set it up for me two years ago…so everything is rock solid.” Usually, without much probing, I soon learn that little else has been done since then. I will typically find that even the attorney may have missed a few steps along the way! In fact, we have uncovered 24 mistakes/traps that LLC owners face all the time! Many of these mistakes are even made by attorneys, experienced business owners, and very talented people. So if you want to avoid disasters and create a ‘rock solid’ LLC…let’s get started!

While I can’t cover all 24 mistakes and traps in this article, let’s talk about the first 5 mistakes in some detail:

1) The ‘Fatal Death’ Personal Liability Clause

A handful of states have a strange option in their articles of organization forms which can be d-i-s-a-s-t-r-o-u-s. Some states require the filer to select whether or not LLC members will be personally liable for the business debts of the LLC. Obviously, members should not be personally liable for LLC debts and obligations! This is the reason you are forming an LLC to begin with…remember? Carefully read the articles of organization or similar formation documents in all states. Make sure that you and your attorney do not accept member personal liability for business debts. If you had an attorney or filing service submit your organizing documents for you, then it is always a good idea to ‘double check’ this area. Make modifications if needed. You would be surprised how many times it’s a secretary, legal assistant or clerk who actually completes your precious articles of organization. Just because a box exists, this does not mean you should ‘checkmark’ it!

2) Not Maintaining “Required” Records

Here is an area where much confusion exists. When I talk about required records, I almost always get the same response, “I don’t want to keep records…that’s why I chose the LLC over a corporation!”

Hold on one minute…because you may be surprised to learn that almost every state requires the LLC to maintain certain key records. In fact, maintaining ‘key records’ is one of the few ‘formalities’ that states do impose on the LLC. As a result, this can be a prime target area of attack if a suing attorney, the IRS, or a bankruptcy court wishes to ‘set aside’ or ‘penetrate’ the LLC.

We have reviewed this area in much detail for all 50 states and D.C., and I can tell you that each is different. Regardless of what your attorney, accountant, best friend, or local guru tells you, this is a must do area! Some common records include: copies of resolutions, unanimous consent forms, copies of meeting minutes, tax returns (from 3 to 6 years), the names and addresses of all current and former members and/or managers, a copy of the operating agreement and more!

3) Failing To Understand and Review Your Operating Agreement

This is an all too common mistake. The operating agreement is perhaps the most important document of the LLC! The operating agreement is an ‘internal’ set of rules for the company. It is basically a contract among members of the LLC. Even if you are the only LLC member this document is very important! We continually find that many business owners have a generic operating agreement that has never been reviewed or even signed by members!

Even worse, most operating agreements are usually missing some KEY components. In fact, we have isolated 43 to 45 key components that must be included in almost all operating agreements. Most canned and even ‘customized’ agreements only contain about 25 to 30 of these components. At a bare minimum, you should understand what the ‘best practices’ are regarding operating agreements and then compare this ‘gold standard’ to what you have. Special tax treatments for the LLC (such as the popular S-corporation tax treatment under Sub Chapter S) will require additional terms and controls!

4) Failing To Complete the “Big 10″ After Forming The LLC:

It does not matter whether you file the LLC paperwork yourself, hire an attorney or other service these things must be completed. This is one mistake we see over and over again! Most business owners routinely forget to complete the ‘Big 10’ important steps within 30 days of forming the LLC. Here are 7 of the steps:

1) Conduct the First Organizational Meeting of the LLC – This is really important and will allow you to create solid safeguards and ‘often forgotten’ controls. There are about 11 things that should occur at this meeting!
2) Obtain Employer’s Identification Number (‘EIN’) from the IRS
3) Register Your Business Name with the County Name Registrar
4) Register with your State Department of Revenue and Comply with State Sales Tax Rules
5) Collect Member Capital Contributions and Transfer Cash or Hard Assets into the LLC (With proper instruction this is simple…if done incorrectly a liability disaster can occur!)
6) Obtain the Proper Business Licenses
7) Review Insurance Coverage Needs and Limitations

5) Failure To Properly Evaluate And Choose Your Team Of Professionals:

This is perhaps one of the toughest things for the real estate investor and small business owner to do. Part of the problem is that most of these professionals (e.g., attorneys and accountants) will know more than the average business owner regarding legal and tax issues. Sometimes the big mahogany desk and the plush office will make them seem even smarter! Take it from me, ‘ivory tower’ law and accounting programs really don’t teach you how to run an LLC for maximum tax savings and asset protection. It seems to be a lost art these days! The truth is that the competency of legal and tax services can range from great to very poor! You need to be able to evaluate this for yourself!

The challenge is that most people who contact an attorney or accountant rarely have a true two-sided discussion! After all, it’s nearly impossible to ask the right questions and comprehend all your of options unless you fully understand the choices and variations available. The Answer: Educate Yourself First! One thing that I have learned over the years is this: no one will care as much about your business as you. It may be sad but accept this today…in fact, right now! Take advantage of top quality home study systems and detailed instruction. Learn about your options and the ‘best practices’ for real estate investors and business owners. Seek out those who want to help and educate! Then when evaluating an attorney or accountant you can ask them the ‘tough’ questions and see if they can answer or if they squirm! Doesn’t this sound like a better position to be in? You will be better able to choose your team and you can ensure that the person who cares the most about your business can make informed decisions about the business!

I’ve been asked if you give someone a life estate, do they have the right to do anything they wish with the property, such as move out and rent it for income? What are an owners rights to the property after they have given someone else a life estate on it? ( such as: are they allowed to go on the property for inspection to make sure the property is maintained and kept up?)

A life estate is a form of interest in a property that allows the person with the life estate to retain full interest in the property until their death, but vests legal title in another person. It is most commonly used when an elderly parent wants to transfer their home to a child before their death, but wants to continue to occupy the property until that time. But it’s also a great, creative way to put together deals with older sellers who want to pull the cash out of their home but have the right to live in it until the end.

Yes, the holder of the life estate has the right to lease—or even sell—the property subject to the life estate. In other words, the tenant or buyer gets the rights to the property only for the lifetime of the person to whom the life estate has been granted. And yes, the owner of record (you) has the right to enter the property for the purpose of inspection with notice and at reasonable intervals. If the “life tenant” (as the holder of the life estate is called) isn’t maintaining the property, or is doing anything that will permanently damage the value of the property, the remainderman (you) can sue the life tenant for damages. You, however, are the one ultimately responsible for paying taxes, insurance, assessments, and so on.

Granting someone a life estate on a property that you intend to eventually make a profit on is clearly a risky proposition. It’s entirely possible that the holder of the estate could outlive you, or outlive the usefulness of the property to you. Remember Jeanne Calment, the French woman who lived to be 122? In her 80s, she sold her apartment to Andre-Francois Raffray, who gave her a life estate and promised to pay her $500 per month until her death. By the time of his death in 1995, he had paid twice the market value of the property. Her comment: “Sometimes in life, you make a bad deal”.

Perhaps of greater concern to you is the possibility that the expenses that you pay on the property might exceed the value of the property by the time you actually get possession. For this reason, you need to put pencil to paper before making an offer and figure out exactly what will happen if the life tenant lives 5 years, 10 years, 20 years, or until he’s 122. In all likelihood, you will discover that your offer will need to be even more below-market than usual—possibly as little as 20-30% of the as-is value.

By the way, there are 2 other strategies that might be better suited to your ends. One is called an Estate for Years, which grants the seller an ownership interest in the property through a certain date—which can be as long as makes the seller comfortable, and gives you the ability to plan when you will get ownership. You can then agree on the price of the property based on the length of the period. The other is a reverse mortgage, where instead of paying the owner a lump sum for the property, you make him monthly payments for some period while he continues to live in the property. Either of these should meet an elderly seller’s need to continue on in his home while receiving an income for it.

POINT # 1: Many investors believe that they can create a limited liability company (LLC) or file a corporate charter with the state and always have liability protection. This is simply not true. The truth is that each of these business entities (the LLC, the corporation and even the limited partnership) require certain key steps after the structure is created. I always like to compare business entities to a fancy Italian sports car or a new baby…they will demand proper care and feeding! They are fun on the first day, but you had better know how to maintain them. You can’t neglect the baby or take the fancy Italian sports car for a spin without any oil in the engine. If you do then a disaster is coming! Many new business owners believe that because they hired an attorney or service to create their new business entity, the work is done. The truth is that what you do after the entity is created is most important. There are countless nuisances, details, traps which must be understood in order to maintain liablity protection.

POINT # 2: If you plan on going into business with another investor or what you might call a partner, consider this: What happens if there is a disagreement? Do you have to sue, do you use mediation, do you have procedures in place to require efforts to settle things out of court? What happens if one of the parties in the business wants to sell their ownership interest? Who will buy it? What will they sell it for?

Here Is A Typical Scenario

Assume that you go into business with your best friend Tom. Things are going great but Tom decides that he needs to spend more time with his elderly parents. He wants to sell you his part of the business but you tell him, “Just wait a bit, Tom”. “Things will get less stressful soon”. He agrees but shakes his head in doubt. The next day you learn that he has sold shares in the business to his uncle. You now have a new co-owner. You never would have started the business if you were going to have to work with Tom’s uncle. These types of situations can be avoided by utilizing proper ‘buy back’ agreements between co-owners and limiting transfer rights. Sadly, most business owners never learn about these precautions until it is too late.

POINT # 3: For real estate investors there are always risks when the owner of a property decides to make repairs on the property or hire someone to make repairs for them. It does not matter if you have a business structure or not: A business owner is always personally liable for negligence. So if you are negligent when you make a repair or negligently ‘hire’ someone to make a repair, you can be sued personally. Don’t ever forget these words: “Business owners can be sued personally for negligent acts”. It’s really important that you spend just as much time learning about the limitations of business entities, rather than just hearing about all the benefits!

Tax and Asset Protection Choices – Possible Contradictions?

POINT # 4: When trying to choose a business entity: Be Warned! There are a number of opinions out there depending on who you ask. I’ll try to make this really simple so remember the following: You are fighting two battles. The business and tax structure you choose is your weapon/protector. What are these two battles?: 1) a tax battle and 2) a liability or asset protection battle. In other words, when you choose a business structure type (corporation, LLC, limited partnership) the choice for the real estate investor will depend on the tax issues which are associated with the business, and how well the business structure protects personal assets from the activities of the business. Certain structures can protect the assets of the business from personal liabilities (please see my article, ‘Corporations and Limited Liability Companies (LLC’s): Charging Orders and the Differences in Protection’.

Most real estate investors will go to their attorney in order to find out which business structure makes the most sense from a legal standpoint. Usually the main question is, “Mr. Lawyer or Ms. Lawyer which business structure will protect my personal assets if my business is sued?”. Later that week, the same investor also travel across town to an accountant’s office and ask, “Mr. Accountant or Ms. Accountant, which business structure will save me the most in taxes?”.

Notice A Few Things:

There could be different answers. Most attorneys will have a dynamite understanding of the legal issues (in this instance personal liability protection issues), however they may not be as informed on the complex tax issues associated with real estate or other industries. So their answer may be help you from a liability standpoint, but hurt you from a tax standpoint. The same is true regarding the accountant. They may have great choice for you when it comes to taxes, but a bad choice when it comes to personal liability protection. Usually, the biggest trap comes in the form of a good liability protection choice, but a horrible tax choice. This is especially true in real estate. If you ever receive conflicting advice be sure to understand exactly why it is conflicting. For example, are there really contradictions or perhaps is the professional giving you legal advice, but not considering the tax issues. The same is true regarding tax advice. I like to say that you need to educate yourself on all the options available and some of the most common issues and structures that investors like yourself use – day in and day out.

POINT # 5: All professionals are not created equally. In order choose a capable attorney or accountant you need to be able to evaluate them. How do you do this? An excellent way is to ask them questions which relate specifically to your business/industry. While some investors have a pretty good understanding of the tax and liability issues…many do not. Because of this many business owners choose an inadequate attorney or accountant for their business. After all how can you evaluate the accountant or the attorney for you if you don’t understand all your options? How can you really ask pertinent questions? How can you evaluate their skill level? How can you really be sure what they are telling you is up-to-date?

You really need to have some knowledge before you walk into the plush law or accounting office. It will not only help you make the right choices, but it can also Save You MOney! If the attorney does not have to create an entire set of forms for you…then you will save several hundred dollars or more. If you have run your entity properly and understood accounting rules and IRS requirements, then there is less work for the accountant to do. With the right information you can choose the best professional and usually save a good deal in professional fees. You make your life and their job easier! Get educated first!

First, let me state that I’m not an attorney and the rest of this article is just based on my experiences so I’d advise you to contact John Hyre at www.realestatetaxlaw.com to get some solid, specific advice on your particular situation.

Also, this article is not going to discuss land trusts, which some of you may have just stumbled upon. A land trust is not an entity. Although it is frequently used in conjunction with entities, it is merely a paper device used to shield property ownership from the public.

When I first got going, the recurring wisdom was that an investor should use a C corp for cash deals. By cash deals, I mean anything that throws off cash quickly. It might be a wholesale flip, retail assignment, rehab and retail, option, etc.

There were numerous reasons why this was and is recommended. First, the C corp offers great liability protection and allows the owner to take advantage of fringe benefits, thus draining the corp of excess profits through legitimate expenses.

What I’ve learned the hard way is that this entity is not necessarily better for cash deals than other entities unless you’re doing serious cash numbers. By this I mean that the added benefits that a C corp offers are not available to you without a ton of cash coming in.

Stop and think about it for a moment. Are you going to generate enough cash to pay normal operating expenses like salary, marketing, funding, overhead, etc. and still have cash remaining to set up company programs for retirement, medical, insurance, education, etc.?

Typically, the answer’s going to be “No”, at least during the formative years. The primary downside to a C corp is that any losses, paper or otherwise, do not flow through to your personal tax return. You don’t get to use them anytime soon.

When I started, the secondary recommendation for cash deals was an S corp because it did offer many of the same benefits as a C corp, yet allowed the owner to flow losses through to the personal tax return. Once the business was thriving then converting to a C corp was not difficult.

When I went through this research again about a year ago, the majority of responses I received was that I should use a Limited Partnership (LP) for cash deals with a Limited Liability Company (LLC) as the General Partner (GP). I’ve also heard others suggest using an S corp as the GP. Other recommendations included using an LLC by itself as the cash deal entity.

What about entities for the keepers? By that I mean any property that hangs around for a while and doesn’t cash out soon. It could be a rental, lease option, or any property with owner financing, including subject to (Sub2). What I was told there was the same; that an LP with an LLC as the GP was currently best.

The point here is that if you do spend the necessary time to research this issue (and you should), you are likely to get each of these responses and possibly more.

My experience is that any of these suggested entities is better than starting with a C corp as I did. Factors that should play into your decision process include setup costs and any state-specific laws for each of the entities. For example, in my state, Texas, the LLC is much cheaper to set up than an LP. However, the LLC is also subject to franchise taxes on gross receipts over 150k and the LP is not.

Confused? I agree it’s not easy to know what the right course of action is. Do you need an entity or multiple entities established before you do some deals? Absolutely not. Why go to the trouble of setting up companies for a business that you may decide to discontinue? How do you know if you’ll even like real estate investing until after you’ve done some deals? Why do you need to set up serious asset protection until you have something worth protecting?

My recommendation would be to begin to research the various entities for your state as you continue to work your investing business. In my opinion there’s no need to make things complicated in the initial stages. If there’s no obvious negatives to an LLC in your state, then perhaps that would be a good start.

I would not rush out and set up a separate entity for cash deals and a separate entity for keepers as I did. I would not set up an LP as my first entity as it involves at least two partners, one limited partner and one general partner. Entities are not set in stone. With the proper guidance and counsel from good attorneys and CPA’s, you can make changes to your business plans as the business grows.

Again, this is not something you have to figure out when just starting. Find someone very knowledgeable about real estate investing, like John Hyre mentioned above, and begin to ask the tough questions so you can make informed decisions. As your business grows, your asset protection can grow with it.

There are over 80 million lawsuits filed every year in the United States. Landlords and real estate investors are especially susceptible to liability. Are you a target? Are your assets easy to locate? Is your real estate titled in your name?

You wouldn’t walk around with a financial statement taped to your forehead would you? So why would you have your most valuable assets exposed to public scrutiny? Anyone can go down to the county courthouse or recorder’s office and look up the owner of any property. Real estate records are now computerized, so all of your real estate holdings can be located at the touch of a button!

Any mortgages on your property will be recorded as well. Most recorded mortgages will state the amount of the original principal balance and the date the mortgage payments began. All one has to do is figure out the balance of your mortgage and subtract that amount from the market value of your house. Bingo! Now they know how much equity you have and hence whether suing you is worthwhile.

If a tenant or creditor is contemplating suing you, he will make an appointment with a lawyer. Unless he can afford an attorney by the hour ($150 and up), he will likely seek a “contingency-fee” lawyer. A contingency-fee lawyer does not charge by the hour; he charges a percentage of whatever he collects. Most contingency-fee lawyers will not take a case unless there is something upon which to collect. If you have no real estate in your name, then finding out your ownership interest will not be easy for a typical lawyer. It’s not that lawyers are lazy. It’s simply a matter of allocation of resources; lawyers focus on cases they can win and collect. If they don’t find any assets in your name (and there is no other apparent “deep pocket”), they probably won’t take the case. As you can see, appearing “broke” is the best lawsuit-repellent money can buy!

There is another problem with owning real estate in your own name. If a judgment is obtained against you and filed in any county in which you own real estate, all real estate in that county will have a lien attached to it. You cannot sell or refinance any property in that county, since no title insurance company will guarantee a clean title. You’re stuck until you pay off the lien.

Some people use a corporation or limited liability company to hold title to their real estate. While these entities will protect you, they will not protect your property. If you own all of your properties in one corporation, a judgment against the corporation will create a lien on all property owned by the corporation. Furthermore, the directors and officers of a corporation are public record, so a corporation will not hide your ownership.

The solution for holding title to real estate is a land trust. A land trust is a revocable, living trust used to title ownership of real estate. Title to the property is held in the name of a trustee, who is forbidden to reveal the beneficial owner. The beneficial owner or “beneficiary” can be an individual, corporation or other entity for further protection. Land trusts were first used in Illinois, hence the nickname, “Illinois Land Trust.” In nine states (AL, FL, GA, HI, IL, IN, ND and VA), land trusts are specifically recognized by statute. In most other states the validity of land trusts are supported by common law and general trust principles (land trusts are not recognized in TN & LA).

A land trust, if properly setup and implemented, will hide your name from the public records. No one will know who owns the property but you, your attorney and the trustee. If a judgment is entered against you, a lien will not automatically attach to the property, since title is not in your name.

A transfer of realty into a land trust virtually no income tax consequences. A land trust is considered a revocable “grantor” trust under the Internal Revenue Code, so it does not require a separate tax identification number or income tax return. Thus, you continue report the property for income tax purposes as though you still own it. Furthermore, a transfer of property into a land trust will not usually trigger the “due on sale” clause of your mortgage.

A land trust will allow you to assume an FHA or VA loan without recourse. Anyone can assume an old FHA or VA loan without qualifying, but few investors realize that such an assumption is with recourse. If the investor sells the property and the buyer assumes then defaults on the loan, the investor (and anyone else who previously assumed the loan) may be held liable. If a land trust is established to take title to the property and assume the loan, there is no recourse against the beneficiary. Furthermore, the loan will not appear on the beneficiary’s credit report as a liability. So What are your waiting for?

Get that Property Out of Your Name!

A business entity can provide personal liability protection for its owners. The problem is that many people start business without proper instruction on how to run and manage agreements between parties, agreements with customers, internal paperwork, cash controls, voting rules, state and Federal reporting requirements and a host of other issues.

In fact, we have found between 20 to 25 actions, behaviors, or neglected tasks which commonly cause a business structure to be forfeited and can result in personal liability for the owner or owners. Here are 5 of them:

Using The Business For Fraudulent Activities

You Cannot, Should Not, and Shall Not use your Business to Cheat or Defraud! For example, John Smith gathers money from investors claiming that he will develop a new product for his company. He never had planned to use this money for product development. He is sued by the investors, but John claims that his personal assets are protected since he was acting as the president of his limited liability company. No court will honor the limited liability company since fraud was involved. His personal assets and business assets will be at risk.

You may think that since this is an egregious example, it won’t ever happen to you. However consider the fact that many deals struck with the so-called ‘motivated sellers’ could give rise to a lawsuit under your state’s Deceptive Trade Practices Act (DTPA) or similar statute. Sometimes the line is not so clear. One bit of wisdom is to make sure that your agreements are fair:

You also can’t be wholly unfair or flagrantly one-sided when dealing with customers. A court can always look at a one sided transaction and either decide against you. Even worse a judge could declare that you are using the business to promote unfair dealings. This is bad news for you!

Ask Yourself: Would you want to be the buyer/customer on the other end of your deal? Despite popular conception you can structure ‘win-win’ deals with motivated sellers and make money. Ever hear of karma? Everything you do to or for another person will one day be done to or for you…so be fair!

Failure To Respect The Business As Separate From Its Owners

You shall not mix funds from business accounts with your personal funds, accounts, etc. Do not use company money to buy personal assets, groceries, etc. Simply put, if you do any of these things routinely (or perhaps only once) then your business structure is not likely to hold up in court. If you think this is another easy one…then WATCH OUT, because there are other more complex issues relating to the use of business and personal assets in the business. For more information see some of our top-rated courses.

Insufficient Capitalization: The Failure To Properly Capitalize The Business

In other words, A Lack of Reserves and/or insurance coverage. If your business does not have enough capital and/or insurance to cover operating expenses and potential liabilities then a state court will likely ‘pierce’ the business entity and hold the owners personally liable. Why would a court do this? The reason is to ‘find the money’.

Your business must have enough insurance and/or savings to cover expenses, liabilities, and obligations. The amount of capitalization generally refers to the total value of assets (equipment, cash, etc.) in the company and the amount of insurance coverage. This is another COMPLEX area because you may need more or less ‘capi
talization’ based on your business type. A general rule is: The more you deal with the public, the generally the greater your required level of capital.

Forgetting To File State Reports

Your secretary of state’s office will require you to keep up with reports and state taxes (sometimes called franchise taxes and/or business privilege taxes). If you don’t keep up with these reports and/or taxes (even if nominal amounts are owed) your business privileges will likely be revoked. Guess what privilege goes first?: The personal liability protection.

Other Formalities

These include meetings, paperwork, required records, proper roles and obligations among the parties, and transfers of ownership interests, and more. It is very rare that we see full step-by-step and easy-to-follow details on creating ‘iron-clad’ records in these areas. For state liability protection and the ability to satisfy IRS auditors you need to understand these rules!

The list does not stop here, because we have found between 20 to 25 areas which are common traps for the business owner. While we have covered 5, many of the others are very easy to miss but just as important. Please make sure you get proper instruction on how to run your business entity after it is created! The true ‘lost art’ is learning how to maintain the protection of your LLC or corporation.

I always say that when choosing a business entity, you must evaluate the tax advantages and disadvantages BUT ALSO the level of liability protection.

LET’S EXAMINE A COMMON SITUATION: Many attorneys recommend the corporation to their clients. For the most part, corporations will provide good protection from ‘traditional liabilities’. In other words, if the business is sued for its business activities, then I consider this a ‘traditional liability’ situation. In most instances (a properly set up and maintained corporation) will protect the owners from personal liability.

Most attorneys (myself included), who stay up-to-date with court precedents and how creditors (and collection attorneys) actually work, will tell you that a multi-member LLC will usually provide enhanced benefits. Here are a few reasons:

Less Formality = Less Mistakes

The corporation requires annual meetings and has a number of rules which create a ‘forced’ management structure. For example, every corporation is made up of a ‘tri-parte’ management structure (tri-parte means 3 levels). This means that all corporations will have to ‘force’ or channel operations through this structure of directors, officers, and shareholders. The trouble with small to mid-sized businesses is that the same person or perhaps a handful of people must occupy all of these positions. This can create confusion and more opportunity for error. The limited liability company (LLC) is simpler to operate because state law does force this ‘tri-parte’ structure upon LLC owners and employees.

LLC’s (unlike corporations) are not required to have annual meetings. Although we think LLC meetings are a good idea, you probably won’t lose your protection if you forget to have a meeting. These simplicities mean less technicalities and less confusion. It also means that there will be less mistakes available for an attorney to use against you when trying to ‘pierce’ the entity in order to hold its owners personally liable.

Charging Order Protection

Alright, let’s move forward to another VERY IMPORTANT issue. I am going to say that this is perhaps the KEY REASON why an LLC is favored in most situations. The LLC will protect you from business liabilities but it can also protect your business from personal liabilities. DID YOU CATCH THAT? We said the LLC will protect you personally from business liabilities, BUT IT CAN ALSO protect your business from personal liabilities. Ok, enough word manipulation…let’s look at a concrete example:

EXAMPLE: Let’s say that you are driving and taking your family to the park on a Sunday afternoon. Negligently, you tap someone who is crossing the street and they are slightly injured. The injured person finds a sharp and hungry personal injury attorney who ‘milks’ the case for every penny. They sue you for $1,000,000 and win. Your insurance pays out the $500,000, but there is still $500,000 owed. What happens next? The answer will depend on whether you have a corporation or LLC.

Did you know that once a judgment is obtained against you, the attorney may pass the case on to a collections specialist (an aggressive attorney who handles collections)? These attorney’s are very knowledgeable and may only focus on collections – in other words, they know the ropes. This attorney would go to the judge and request a Write of Execution. With this writ they many visit your residence or office (with the local sheriff) and begin seizing personal assets. The problem is the corporate stock shares are personal property. As a result, generally they can seize 100% of corporate stock shares.

Now you may say…’Wait a minute, my business was not involved in the accident”. “I was taking my family to the park on a Sunday”. Understand, the creditor is not trying to enter your corporation through the front door, but through the back door! Have you ever heard the _expression, “He who has the gold makes the rules?”. I don’t always agree with this, but in this situation, let’s say, “He who has the stock shares makes the rules”. In other words, if the creditor seizes your stock shares they can vote to dissolve or end the corporation. As a result, any assets in the corporation must be ‘distributed’ to you personally.

Now you may ask, “Why would anyone want to break up my corporation?”. THE REASON: Once the corporation is dissolved the assets of the corporation will be distributed to you, the owner. GUESS WHAT? Now the collection attorney will have more money to satisfy the rest of the judgment (the $500,000 still owed). Remember we discussed the importance of protecting your business from personal liabilities? The corporation won’t do that very well because of this reason: Stock shares are personal property. They can be seized if you have a personal judgment against you.

The same thing can happen if you are doing business in a corporation made up of 2 or more parties. In such an instance, a creditor who obtains enough shares could vote to dissolve the company or they could become a substituted owner. You see, you can’t control the actions of all your co-owners all the time. For this reason, there is undue risk when corporations are used (especially if there is more than one owner!).

Learn To Avoid These Traps Before They Happen!

I am a licensed attorney and attend training conferences each year to keep up with my required hours of continuing legal education. I can tell you that while I love to learn about all the updates and nuisances of setting up companies…I know that the real benefit comes from understanding how collection attorneys work. The goal is to learn what tricks they use to tear companies apart. Believe me, most will foam at the mouth when they learn the business owner is using a corporation. They are not so pleased to learn the business owner is an LLC or other ‘partnership-style’ entity.

So at this point you may be wondering how the LLC is different. This is a complex issue, but generally we can say that the laws of all states (except Pennsylvania and Nebraska) have included special rules for LLCs which allows them to be protected in this type of situation. In other words, if we had the same facts in which you hit someone on the way to the park on a Sunday and $500,000 of the judgment was not covered by your insurance, the creditor would generally not be able to gain control of your LLC. The creditor also could not vote to end the LLC, could not force a ‘distribution’, and could not break up the LLC. The creditor would be limited to a court order called a ‘charging order’.

So what is a charging order? The charging order is a specific court order that first must be granted by the judge. It is a court order which says that if any money is passed on to the owner who was involved in the accident, this money must first go to the creditor until the debt is paid off. The only problem is that the creditor does not have the right to force the LLC to make this payment. This means that the creditor could wait a very long time for such payment to be made. If your LLC is run by parties who are ‘friendly’ to your situation, they may choose to stop all distributions made to you. State law limits a creditor’s collection efforts to this charging order. Second, once the creditor obtains the charging order they may have to pay taxes on money that the LLC made, but which was not distributed to you (we call this ‘phantom income’).

What does all this mean? Generally it puts you in a much better position if such an event occurs, since it may force the creditor to try to settle the judgment debt or just drop the collection efforts. At the very least it can help keep your business intact. If you were using a corporation the end result would likely be the end of the company. If an LLC was used, managed correctly, and its owners properly reserved this charging order limitation then the result will be quite different.

A Few More Points To Consider

Here are a few other things to consider: An LLC will need to have more than one member in order to ensure this type of protection. Let’s also say that in community property states it may be useful to have someone other than your spouse (family member or close friend) own a small percentage interest in the LLC. The community property states are: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin.

Second, you must make sure that the LLC is run and managed in the correct manner. None of these protections will hold up in court unless you truly become a MASTER of good business practices and learn how to keep up with LLC formalities.

One of the most common questions that real estate investors ask is: Which entity should I use? The correct answer usually depends on a large number of details…the exact nature and size of the business, the investor’s source and type of income, the number of family members, etc. This article will set out some general rules for picking a structure. Your mileage may vary based on your own personal facts and circumstances.

Rule One: Limited Liability Company’s (a.k.a. – LLC’s) are generally the way to hold rentals and most lease-optioned properties.

The asset protection aspect of entities usually matters little when selecting an entity. That’s because in most states, LLC’s are cheap, provide the best asset protection and are tax chameleons, meaning that they can select how to be treated for federal income tax purposes. So when I say that a corporation works best for you, what I really mean is that an LLC that elects to be treated as a corporation is the best choice in most states.

What really distinguishes entity types is the tax treatment accorded each one. As such, choice of entity usually turns on the applicable tax rules. In fact, tax rules will determine the best entity for rentals, because they are the little darlings of the tax code. Specifically, rentals:

* sell at favorable capital gains tax rates;

* generate depreciation deductions;

* generate tax upon sale that can sometimes be paid in installments, instead of all at once;

* can be exchanged for other real property tax-free; and

* may generate low-income housing credits

We want to select an entity that preserves these tax perks. Limited Partnerships (“LPs”) and Limited Liability Companies (“LLCs”) both achieve this goal better than any other entity. In most states, an LLC is cheaper and simpler to set up and run, so it is normally preferable to an LP. In addition to preserving rental property tax perks, LLC’s are the most flexible entity. Corporations have various restrictions on who can be an investor, what kind of income can be earned, etc. LLC’s are thankfully free of such pesky (and time consuming) issues.

Rule Two: S-Corporations are usually the best way to flip properties.

First, let’s distinguish S and C corporations. A C-Corporation is taxed on its income at special corporate rates. Any income that is paid to shareholders as a dividend is taxed again. This is the famous “double taxation” that applies to C-corporations.

For example:
Trumpco Incorporated earns $10,000 in taxable income. It pays a 15% tax on that income, or $1,500, leaving with $8,500 in after-tax income. It pays an $8,500 dividend to Trump, its owner. If Trump is in the 35% tax bracket, he will pay $2,975 in taxes on the dividend, leaving Trump with $5,525 of the original $10,000.

This double tax can quickly cost corporate shareholders more than 50% of their corporation’s profits. Fortunately, the income of a C-Corporation can often be finessed to reduce the double tax. Oftentimes, creative means of getting money to shareholders (e.g. – renting equipment to the corporation, taking salaries, etc.) can also eliminate one layer of taxation.

To offset the double tax (or the administrative cost of getting around it), C-corporations have a few unique perks enjoyed by no other entity. Employees (including shareholder-employees) can get certain benefits (e.g. – medical, favorable retirement plans, tuition payments) tax-free.

S-Corporations do not get the above perks, but they also do not have double-taxation issues. As such, they are “pass-through” entities. Following the Trumpco example from above, the $10,000 dividend to shareholders would only be taxed once, at the shareholders 35% rate. S-corporations are much simpler than C-corps, and therefore cheaper to operate. They are less flexible than LLC’s, but have one important advantage: S-corporation dividends are exempt from social security taxation if the S-corporation owners are paid a reasonable salary. This feature is quite important, because income from flips (as opposed to rentals) would otherwise be subject to a 15% social security tax.

For example:
The incredible Flipboy makes $80,000 in net income from wholesale flips done through an LLC. He would pay approximately $12,000 (15% of $80,000) in social security taxes. If he used an S-Corporation and paid himself a “reasonable” salary of $35,000, he would only pay social security tax on the salary, or $5,250. The remaining $45,000 in profits would be distributed without paying additional social security taxes, saving Flipboy $6,750 in social security taxes.

Limited partnerships are also exempt from social security taxes. Arguably, LP’s are not required to pay a reasonable salary, meaning that all of the LP’s profits can be sheltered from social security taxes. The catch: LP’s are significantly more complicated than S-corporations and therefore more expensive to run. The extra benefit of an LP over an S-corporation for flips must be weighed against the cost.

Rule Three: C-Corporations often make sense for high-income individuals with self-provided benefits.

As we stated above, C-corporation can provide certain perks and benefits tax-free. If you do not have a day job (or a spouse with a day job) that provides such benefits, getting them through a C-corporation can be very efficient from a tax standpoint. Also, I mentioned that C-Corporations pay taxes based on their own brackets. For example, the first $50,000 of C-Corporation income is taxed at 15%. For people in the 35%+ tax brackets, running $50,000 or so in income through the C-corporation at a 15% tax rate can be quite favorable. I say “can be” because C-Corporations are fairly expensive to administer. Remember, the benefits must outweigh the costs (e.g. – extra tax returns, bank accounts, etc.).

I rarely place a major business in a C-Corporation. Instead, I like to see secondary businesses put into a C-Corporation. For example, a C-Corporation that manages your rentals is paid what you choose to pay it (within reason!). You can pay it enough to fund your benefits, but not so much that double-taxation becomes an issue. If you put a major business into a C-Corporation, it may make “too much” income. At worst, the double tax kicks in, costing you big dollars. At best, your tax advisor finds a way to bail the income out of the company….and charges handsome fees for the favor! In my view, it is much easier to put the C-Corporation on an “income diet” than it is to “lose” the income later on (Sound familiar?).

Rule Four: Incorporate in Your Home State

I have yet to see a Nevada entity used to hold or flip properties that justified its cost. All of the benefits promised by Nevada entity hucksters (e.g. – privacy, no state tax) DISAPPEAR because you are doing business in YOUR state. Nevada entities CAN be used to reduce income taxes in SOME states by charging your in-state company interest – talk to someone familiar with YOUR state’s rules to see if such an arrangement is legally possible AND worth the cost and hassle. Do NOT accept the word of a guy who sells Nevada entities for a living. Shockingly, he will assert that a Nevada company will save taxes, promote privacy, make you better looking and cure cancer…all without having the first clue about the laws in YOUR state. To a guy with a hammer, everything looks like a nail!

Rule Five: Your Mileage May Vary

These are general rules. Your business, personal situation or state’s laws will often make for exceptions to the general rules. Get qualified advice!

A limited partnership is a partnership that has at least one limited partner and one general partner. Most states require the filing of a certificate with the state in order to be recognized as a limited partnership.

The limited partners generally have no liability beyond their contribution to the partnership. If the limited partnership business fails, the creditor cannot go after the limited partners for debts (there are a few minor exceptions to this rule that are not difficult to avoid). Furthermore, limited partners are not personally liable for wrongful acts committed by the other partners. In exchange for this limited liability, the limited partners give up their right to participate in the control and management of the partnership.

The general partners run the management of the partnership. The general partners control the cash distributions to the partners. The general partners also have unlimited liability, as in a general partnership. Creditors of the partnership can look to the general partners’ personal assets if the limited partnership’s assets are insufficient. Furthermore, the general partners are liable to third parties for wrongful conduct within the partnership business (e.g., a “slip and fall lawsuit”). Thus, a corporation is usually better for pure liability protection for its owners.

The limited partnership does not pay taxes as an “entity.” It files an informational tax return to the IRS. It issues a form K-1 to the partners who include the partnership income or loss on their personal tax returns. The partners must pay income tax on all gains whether or not the profit is distributed.

Creditors of individual partners cannot take a partner’s place in the partnership. A creditor may garnish the partner’s share of income (called a “charging order”), but has no right to participate in the management or utilize partnership property. Thus, if a limited partner’s income is garnished by a creditor, the general partner (who should be under the limited partner’s control) can frustrate the creditor by not distributing income to the partners. Since a partner is required to pay taxes on his share of the income whether or not the income is distributed, guess who gets the tax bill? You guessed it, the creditor! If your assets are held in a limited partnership, they are virtually judgment-proof!

The Family Limited Partnership

Let’s look at a variation known as a “family” limited partnership. Suppose that you and your spouse create a limited partnership to hold your family’s liquid assets. Your limited partnership contributions are all of your stocks, cash, CD’s and mutual funds totaling $300,000. Your partnership agreement could state that your spouse will act as general partner with a 2% share (the size of the general partnership share does not affect the general partner’s power to manage the partnership’s affairs). You agree in writing that your contributions constitute a 98% limited partnership interest.

The partnership agreement could further state that the limited partnership shall have the right to buy out the general partner for his share of the partnership and appoint a new general partner to replace her (the “you” in this example is the husband; we are making the wife general partner because we assume that husband’s risk of getting sued is higher; if the opposite were true, then we would arrange the partnership accordingly).

Let’s say that you are sued and a creditor obtains a $50,000 judgment against your name. The creditor can attach your limited partnership interest but only to the extent of your income as a limited partner (called a “charging order”). The creditor who attaches a limited partnership interest cannot participate in the management of the partnership, and thus cannot force the general partner, your spouse, to distribute income. As general partner, your spouse stops paying the limited partners’ distributions, because in her discretion the limited partnership would be better served to reinvest the capital.

One year later, the creditor still has a $50,000 unsatisfied judgment. Just to top it off, the partnership sends the creditor a form “K-1″ for the creditor’s share of your “phantom” income (In our example, the partnership assets are worth $300,000. At a 10% annual return, your share of income would be approximately $30,000 – the creditor would have to pay income taxes in the ballpark of $10,000! If the creditor does not pay the tax due on your undistributed share of income, the IRS may come after the creditor!). You will be in a strong position to force your creditor to settle his claim for a fraction of its value.

Let’s say a creditor sues your spouse and tries to attack your spouse’s general partnership interest. At that point, the partnership exercises its power under the partnership agreement to buy out her general partnership interest in the amount of $2,000 or 2%. The partnership then finds a new general partner. With proper planning, this may not be considered a “fraudulent” conveyance because the general partner received full compensation for her partnership share.

As you can see, the limited partnership is one of the few entities which affords control over your money, yet still provides you with asset protection.

“Family” LLC’s – To Good to be True?

Another similar tool for protecting your wealth is the LLC or “Limited Liability Company.” An LLC is like a cross between a corporation and a limited partnership. All of its partners (called “members”) have limited liability and all of its members can participate in the management of the LLC without suffering any liability.

Any assets you hold in an LLC are protected from creditors in the same way your assets are protecting in a limited partnership (i.e., the creditor’s remedy is limited to a “charging order”). In addition, since all members are shielded from liability, an LLC may be an excellent device for holding investment real estate – the members are protected from tenant lawsuits and the equity of the members is protected from other creditors.

This article is not intended to alarm or frighten you, but to emphasize the importance of having a “system for doing business and making investments.”

For those of us who invest, have employees, or deal with the public, it is never too soon to take steps to protect our assets and our future. It is better to be four years too early than one day too late.

Most people are fair in their dealings and think they can defend their actions in court, should the need arise. When I was young and financially successful, I felt that way. Now, I know different. I have seen the financial, and sometimes mental, destruction of people who failed to take steps to protect their assets—some of whom I did business with. Over the years, I have had several frightening, close calls of my own. When the need for asset protection occurs, you will either thank heaven you have it—or deeply regret not doing anything before it was too late.

I’m not referring to legitimate claims, most of which can be covered by liability insurance. I’m referring to those who would use the law in an attempt to take assets from honest, hard-working people, based on some occurrence or something someone else has or has not done. In conjunction with their attorney, these people will often make outlandish claims in an attempt to settle out of court, knowing that it may be less expensive than going to court. While not as serious, these extortion attempts can be worrisome and very annoying.

While we may carry liability insurance, it is not always enough. There are numerous risks that are not covered by liability insurance—or the amount of coverage may be insufficient. And, there is always the possibility that the insurance company will not be able to pay in times of need.

With only five percent of the world’s population, America has seventy percent of the world’s lawyers. With nearly 500,000 civil damage lawsuits filed in state courts each year, the odds are that you will be sued four or five times during your adult life. Needless to say, it only takes one lawsuit to destroy any net worth you have been able to accumulate.

It is a lot easier to lose money than it is to earn it. Most of us know people who have inherited wealth only to end up losing it. All of us know people who have spent their lives working to provide for members of their family, accumulating assets they could enjoy in later years. What a tragedy it is when a family loses their life’s savings in a lawsuit or bankruptcy because they failed to plan while their assets were being acquired.

Asset protection and estate planning are subjects that most of us don’t like to think about. We are too busy trying to make money. And, besides, the subjects bring up thoughts of lawsuits or death. We fail to appreciate how much good planning can improve our lives today. So, we decide to wait and do our planning at a later date. In doing so, we overlook the fact that no one can be financially secure without taking steps to protect their assets.

Let’s look at a common scenario: Some person that you may or may not have done business with has a problem. Their problem may be financial, health, or simply wanting to break an agreement they have made. They are advised to see an attorney. They remember seeing the TV ads of Shady Bunch, an attorney with the law firm of Dilly, Dally, Delay and Stall, and decide to contact him.

Mr. Bunch, the kind of lawyer that gives the profession a bad name, “does a little research” and discovers that you have cash in the bank, stocks, bonds, automobiles, real estate, or other assets that could be turned into cash. Mr. Bunch agrees to “take the case on a contingency basis.” All the troubled person has to do is to agree to give Shady Bunch 35% to 40% of whatever the attorney might recover. It’s easy to conclude that, by suing you, he has everything to gain and nothing to lose.

On the other hand, if the lawyer’s research doesn’t uncover any assets that he feels would be worth going after, he advises the client that it may be difficult to win a lawsuit or to collect. However, if they want to pursue the case, he will be happy to handle it for $150 per hour. Realizing that he could spend a lot of money for nothing, the client becomes discouraged, loses interest, and a lawsuit is avoided.

While earning your fortune, it is important that you take steps to protect it. I have spent several months researching the subject of asset protection—both for my own family and for my readers. I have attended many seminars on the subject, read numerous books and newsletters, listened to tapes, and had lengthy discussions with some of the country’s foremost experts on asset protection.

By combining some of their best ideas and adding a few strategies of my own, I now believe that my family’s personal assets are about as secure as they can be.

Corporations, trusts, limited-liability companies (usually referred to as LLCs), and family limited partnerships, can each play an important role in protecting your assets, providing confidentiality, and reducing taxes. However, there is no single entity that will protect your assets from all the serious threats: lawsuits, excessive taxes, probate, and government seizures. To protect your assets from all of these threats, it becomes necessary to use a “combination of vehicles.” Designing the right combination can be the key to success.

Let me emphasize that no asset protection plan is completely fail-safe. Nor, will any plan fit everyone. When the legal system is used by one party in an attempt to take another party’s assets by force, the presiding judge has a great deal of latitude. A judge will often ignore or throw out your written agreements. From the court’s perspective, the fact that a defendant even has an asset protection plan presupposes that it is for the purpose of defrauding creditors.

Instead of an asset protection plan, we should have a system for doing business—one that incorporates asset protection into the way we do business. The asset protection aspects of our system should be incidental—and not too obvious. And, certainly, the term “asset protection” should not be used in our documents or in a court of law.

When challenged, the attorney who defends us against a liability claim will want to be able to show the court that there are legitimate business reasons for what we do. We may also want to show that the entities were chosen partly for estate planning purposes and to minimize taxes. We will not want to give the impression that asset protection played a significant role in the way we conduct business. One exception might be that we use a corporation or limited-liability company in order to limit personal liability when dealing with the public.

On the other hand, if we are challenged by the IRS, we will want to be able to show that there are legitimate business reasons for what we do. And, we may want to show that asset protection played a part in our decisions. However, we would want to avoid or minimize any role that tax shelter played in our decisions. A good plan will, of course, include all these benefits.

Often, under the threat of a lawsuit, people will sell assets at a low price to a friend or relative in an attempt to keep the assets from being lost. Usually, this will not work because the plaintiff’s attorney will be looking for such transactions and the judges will set them aside, ordering the buyer to return the assets. Nor, will it work to form a trust (which requires gifting) at a time when a client is economically troubled and shouldn’t be making gifts to anyone. The plan will not make economic sense, and even if you don’t admit it in so many words, it will be obvious that you are trying to defeat your creditors.

Plaintiffs and their attorneys usually want to acquire cash or assets that can be converted to cash. These may include stocks, bonds, mortgages, automobiles, and real estate with large equities. They do not find real estate or automobiles with large liens very attractive. Therefore, a good asset protection system might involve having large liens on such assets prior to any threat of a lawsuit. With a little creativity, the lender could be a “friendly” creditor under your influence or control.

For example, you may want to use a family limited partnership or family limited-liability company as your “safe haven” and a corporation or limited-liability company for dealing with the public. Handled correctly, a Roth IRA could be a safe place to build tax-free income for your retirement. Because there is a great deal of risk for any entity that deals with the public (such as buying, selling, or renting property, employing workers etc.), you should not allow it to accumulate any significant net worth. The company could operate on money borrowed from the family limited partnership or family LLC which serves as your private bank, charging very high interest rates.

With the correct use of corporations or LLCs, Roth IRAs, trusts, and family limited partnerships, it is possible to have a high degree of protection from all these threats. How these vehicles are used in combination with each other and the wording of the documents is of the utmost importance.

If you set up a well-planned system for doing business and making investments, you will indeed be able to prevent most lawsuits, cut taxes, and maintain greater privacy.