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Archive for May, 2014

Four Benefits of Using an LLC to Hold Real Estate

Posted on: May 1st, 2014 by Debra Rahmin Silberstein

1. Limited Liability

One of the primary reasons for forming an entity, such as a corporation or LLC, to conduct business operations or to hold investment assets such as real estate, is to obtain limited liability from creditor claims, including claims in tort, contract, or otherwise.

Generally, if you own investment real estate in your name alone, or operate a business as a sole proprietor or general partnership, a creditor – such as a customer or tenant injured on your property, or someone who successfully claims that you violated a contract – would be able to access your business and non-business assets to satisfy their claim. For example, if your tenant was seriously injured or killed as a result of a hazardous condition on your property, and obtained a $2 million judgment against you, but your business property was only worth $600,000, and your insurance only covered you for $1 million, the $400,000 balance could potentially be taken, by the creditor, from the value of your personal assets, including your home, other real estate, and savings or investment accounts.

If you transferred your investment real estate to a properly organized limited liability entity, such as an LLC, the creditor described above would generally be limited to the assets of the LLC, plus the value of any liability insurance owned by the LLC. As such, if the creditor’s claim was greater than the value of the real estate plus insurance proceeds, he or she would simply be unable to collect on the claim, and your personal assets would be unaffected.

Limitations on Limited Liability

It is important to note, however, that simply forming an LLC is not a magic bullet that ensures limited liability. LLCs must be operated as a separate entity, and the affairs of the LLC cannot be commingled with your own. Separate bank accounts, accounting, tax returns, and annual filings are required, and the business formalities described in the LLC Operating agreement must be closely followed. LLC owners and managers should avoid using LLC assets, accounts, or credit cards for personal transactions, and should be clear to tenants, vendors, and other third parties that they are dealing with the LLC as an entity, and not the owner in his or her individual capacity. Business cards, letterhead, signage and other materials should therefore clearly state that the business is an LLC.

Failure to sufficiently distinguish the LLC from the owner/manager can result in invalidation of the liability protection offered by an LLC. Further, maintaining the separation of the LLC from the owner can be an administrative burden, and should be weighed against the costs of not forming an LLC and merely purchasing more liability insurance. Additionally, there are initial and annual filing fees involved with forming an LLC. In Massachusetts, the fee is $500 to file the initial documents with the Secretary of the Commonwealth. Annual reports must also be filed, accompanied by an additional $500 annual fee.

Owners and managers should also note that creditors will often ask for a personal guarantee before offering credit to an LLC or other limited liability entity. In such circumstances, the LLC does not protect against liability for debt repayment should the assets of the business fail to satisfy the creditor’s claim.

2. Tax Treatment of LLC Income

Unlike standard “C-” or “S-” corporations, under the IRS “check the box” regulations, an LLC can choose how it wants to be taxed.

Corporations are subject to what’s known as “double taxation.” This means that income is taxed as it is earned by the corporation, and also again when it is distributed to its shareholders as dividends, or when appreciated stock is sold. LLCs can choose to be taxed in this way, but can also choose to be treated as a partnership, or “pass-through” entity for tax purposes. Under this model, income is passed through to the LLC members and added to their personal income, and therefore taxed only once. In many cases, this works significantly to the LLC owner’s advantage.

3. LLCs and Succession Planning

Looking toward the future as the interests of the next and younger generation begins to vest, an orderly transition is going to be increasingly important to minimize potential conflicts and maintain the value of the property. LLC operating agreements can be flexible and structured to obtain a variety of succession planning objectives. Control and ownership of the LLC can be divided disproportionately to allow for the younger generation’s disparate interests and abilities in running the LLC business, or managing the assets. For example, it is possible to create varying classes of membership interest, so that some members may control the LLC and some may not control, but still share in the financial benefits. Similarly, nomination of a specific successor manager allows you to name a specific person who would control daily operation/management of the property in the event of your death or incapacity.

LLCs can be member-managed or manager-managed, and the role of both managers and members will depend on the operating agreement. Generally, the manager operates the day-to-day aspects of the business, and reports to the members. Managers do not have to be members, and members do not have to be managers. Thus, a third party can be named to manage the LLC on the members’ behalf. Consideration should be given to whether the members should be able to remove the manager and, if so, what proportion of the members should be allowed to do so, depending on the identity of the manager. All of these considerations are controlled by a properly-drafted operating agreement.

Limitations on transfer of membership interests can also prevent members from transferring their ownership of the business or investment assets to third parties. These restrictions can, for example, require manager approval of transfers of membership interests, or give the other members a “right of first refusal” to purchase the membership interest.

4. Estate Tax Discounts

These restrictions on marketability also result in discounts for estate and gift tax purposes with regard to the value of the real estate (LLC). Very generally, the IRS may allow the membership interests to be discounted for lack of marketability and/or lack of control. If discounts are desired, a qualified appraiser should be engaged to value the membership interests and determine the discount, and while such discounts are allowed, no specific outcome can be guaranteed.