This is a proverbial (and important) question for the real estate investor. To accomplish the essential task of selecting the right entity, first, you have to look at both the legal and tax side of entities as follows.
The three main types of state-registered entities are
(1) Limited Liability Companies (LLC’S), (2) Limited Partnerships (LP’S) and (3) Corporations (C or S).
Essentially there are two sides to these entities: (1) The LEGAL side and (2) The TAX side.
The legal side is governed by state statute. On the legal side, with the proper entity formalities, these entities all accomplish essentially the same thing – they give the entity owners limited liability and thus protect their personal assets outside of the entity. So the legal is the legal and does not vary that much.
The tax side is governed by a much wider more complex body of federal & state tax law. Accordingly, on the tax side, these entities could vary greatly as to their tax consequences with dollar-saving benefits or costly detriments, depending on which entity is selected. Many times, much of the money is made or lost much more on the tax side of entity structuring than the legal side. Plus the tax side has subcategories such as IRS Audit Proofing where certain entities are audited less than others. Here, you need to stay updated on which entities are on the IRS hit list (discussed in other articles). Armed with this information, if you use the high-audit-profile entity, you do the entity structuring correctly along with IRS audit proofing; or you use another entity if this other entity is just as effective but a low-audit profile.
You have to look at the total picture and look at both sides (with generally more emphasis on the tax side). This two-sided approach is fundamentally important to understanding entity selection & structuring.
Based on this two-sided approach, here are some general rules of entity selection for the real estate investor:
1. LLC’s – LLC-Partnerships are ideal for real estate investments. On the legal side, you form the LLC for limited liability protection. On the tax side, you elect the LLC to be taxed as a partnership giving you the favorable benefits of partnership tax law including a low IRS audit profile. This equals an LLC-Partnership.
Note: For more privacy, you could use land trusts in conjunction with an LLC with the land trust holding legal title to each property and the LLC as the beneficial owner of each land trust.
Limited partnerships (LP’s) are another possible choice for real estate. But, legally, LP’s are more complex than LLC’s, and on the tax side are subject to passive loss limitations whereby the limited partners cannot currently deduct property losses against their other ordinary income such as W-2 income, business income, etc. Managing members of an LLC can avoid such limitations. One of the few times to consider an LP is in states that tax LLC’s but not LP’s. However, these states are very few plus generally the state tax is based on a net amount. Consequently, rental property with low net income or tax losses are often hardly affected. This would lead us back to the LLC.
Family limited partnerships (FLP’s) are LP’s but with family members. They therefore have the same drawbacks as LP’s and are on the IRS hit list.
2. Corporations (C or S) – Are for businesses not involving the ownership of real estate.
Note: Real estate investors should only use corporations in a secondary role, not as a primary entity for real estate. For example, to take advantage of certain C-corp fringe benefit deductions, instead of making the C-corp the primary entity owner of the real estate, or a management company; make the C-corp a minority non-voting partner of a real estate LLC.
Rarely (if ever) use S-corporations for real estate. The “S” stands for small business and that’s what S-corporations are for small businesses, not real estate.
3. Trusts – Estate planning trusts (such as revocable living trusts*) are used to hold title to personal property such as your ownership shares in an LLC; for personal-use property such as your home; for paper\financial assets such as stocks. Trusts should be used in conjunction with state-registered entities such as LLC’s; not in lieu of an LLC.
*Note that revocable living trusts do not give asset protection. However, there are other types of estate planning trusts that also give privacy and asset protection, such as the Life Estate Trust or Intentionally Defective Grantor Trust. These will be discussed in future articles.
Consequently, the ideal set up for most real estate investors is one* LLC-partnership with each property in a land trust, and the members’ LLC ownership shares in an estate planning trust. (*Note: In a later track I will discuss how you can protect all of your properties’ equity in just one LLC).
In the meantime, choose your entities carefully and it will save you substantially from both a legal and especially tax perspective.
Single-Member LLC’s > Beware of Legal & Tax Pitfalls. Single-member LLC’s for real estate ownership are what I call one of The Landmines of Wealth Protection which are touted asset protection devices that may not be all that beneficial.
A Single-Member LLC has little value because, as opposed to a multi-member LLC, it is much more susceptible to having its veil pieced and deemed that it legally does not exist. This would subject the company’s owner to unlimited personal liability for debts or torts of the company. Claimants in cases against single-member entities, in efforts to pierce the corporate veil, often assert that the company is merely the alter-ego of the owner. While there may be a degree of asset protection, with the single-member arrangement, the creditor will find it considerably easier to successfully pursue a veil piercing claim.
The other legal drawback is in most states single-member LLC’s do not get charging order protection.
A charging order is an in-built shield because it’s what’s needed by a claimant in order to attach a member’s interest in an LLC. First off, a charging order is a judicial process, which will require the services of a knowledgeable attorney (probably high priced). Secondly, even with the charging order, the judgment creditor does not have the right to force the sale of the assets of the LLC because they cannot make management decisions for the LLC. For the creditor it could even cause income tax liabilities (without getting any cash). Accordingly most charging orders are never even initiated in the first place. What great protection! In most states a charging order only pertains to a two or more member LLC, namely an LLC-partnership, not a single member LLC.
On the tax side, single member LLC’s file Schedule C or Schedule E, which are very IRS audit-prone schedules. On the other hand, a two or member LLC files a partnership return (form 1065) which is less audit prone than Schedule C or E.
Consequently, two (or more) member LLC’s avoid the legal and tax drawbacks of single member LLC’s.
If you operate as one person and not as a partnership, finding other persons or entities to be additional owners is not difficult. Another member (or other members) could be your spouse, other family members or even better, another entity that you own such as a corporation, trust and/or another LLC. So you can maintain control, these other partners can have small percentages of ownership and/or be non-voting members with no say in management.
While the existence of other owners may not totally defeat a creditor’s claim it certainly can weaken it, and with LLC charging order protection it can do so considerably. Plus there are the excellent tax advantages of partnerships for real estate including a lower IRS audit profile.
So in summary, for your properties you want an “LLC-Partnership”. On the legal side, you form the LLC for corporate limited liability protection. You elect the two or more member LLC to be a partnership giving you charging order protection along with the favorable benefits of partnership tax law.
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August 29th, 2010 at 10:32 pm
Very good articole.
I would like to know also how you transfer a property ( comercial or residential), which has a mortgage held by a bannk, after the LLc has been establised. A typical example will be very much appreciated.
Thank you
Nick