“Business Entity (LLC) Issues” – Lee Phillips

Do you really need a business entity – either an LLC or a corporation? The answer is no, not all of the time. I recognize that it is often easier to set up your business structure first and then actually start doing business. With the Accumulation and Preservation of Wealth set or the LLC Wizard set, it is easy and cheap to set up a business entity and do it right, so you should probably set up your business entity before actually starting business.

I was speaking in Washington State, just across the Columbia River outside of Portland. It was an interesting day. One of the Washington Supreme Court justices bought my Accumulation and Preservation of Wealth materials, which was flattering to me. I also met a man who lamented that he had spent over $25,000 at the lawyers’ offices to set up his business, only to find that he didn’t have any funds left to actually start his business venture.

Having said that, I will often tell people to try the business before they worry about the business entity. Buy a house and flip it. Buy your tax liens and see if you can do it. When you are making money, then get your entity in place. I have seen so many people fuss about setting up their entity and then never actually do any business. You probably aren’t going to get sued on your first real estate deal or business venture. If you don’t make money, the tax benefits of an entity aren’t going to do you any good. As a good lawyer I have to say, get your entities in place and then do business. As an entrepreneur, I will say, just start making money and worry about the details later.

From a financial standpoint, your business entity isn’t going to protect you. Of course, it will protect you if you get sued and that will have a financial effect, but you will always be exposed to the financial risks of the deal. But wait, the corporation or LLC will protect you from the financial disasters of doing business. Right?

Technically, the company protects you as the owner and manager/officer from the financial risks encountered in the business. That is true, BUT as a small company, there is no such thing as company credit. I know a number of groups that make a living getting “credit” for small companies. You pay them and they orchestrate a plan that will build credit for your company. Don’t fall for the trap. I will guarantee that unless you have a $50 million company, you will always be required to sign personally on any loan or line of credit applied for in the company name. Not only that, it is common for the loan company or line of credit to require your spouse to sign also. Try really hard to keep your spouse’s name off everything associated with your company.

Basically, I am saying that in the beginning phases of your business deal, your company gives you very little protection. However, as soon as you get in a deal with a “partner” or employees, you had better establish a business entity (corporation or LLC) immediately.

A Corporation or an LLC?

If you are going to establish a business entity, you need one that will protect you from activities occurring within your business. However, it is almost impossible to protect yourself from the financial activities (loans, lines of credit, etc.). You are going to be held personally liable through the contracts you sign with the banks, office supply stores, building materials supply stores, loan companies, and everybody extending you any credit or giving you money. But you should be protected from the activities of your “partners,” employees, customers, and other people you deal with through your company.

The “corporate shield” that gives you protection from activities within the business is the same in a corporation or an LLC, so either entity will work exactly the same. There is some expectation that there is less “corporate formalities” requirement in an LLC. Your state laws may even say that there are fewer formalities with an LLC, but if the corporate shield is the same, don’t you think the requirements to have that shield be honored by the courts would be the same?

The courts look at the corporate shield and its associated requirements and protections, independent of whether or not it is a corporate or LLC entity, so the formalities should be the same. You need to follow the same rules to maintain your corporate shield, whether you have an LLC or a corporation.

An LLC will give you charging order protection, which a corporation will not give you. Charging order protection protects the company’s assets from the liabilities and creditors of the individual owner(s). If the business is going to have a lot of assets, then you need an LLC not a corporation. If your business entity is going to own real estate, it must be an LLC not a corporation.

A business entity choice is made on asset protection decisions and really no other consideration. How the entity is taxed is an accounting decision, not a legal decision.

How Is It Taxed?

A corporation can be taxed under Chapter C or Subchapter S of the IRS Code. An LLC can be taxed as a sole proprietorship, partnership, Chapter C, or Subchapter S entity. Obviously, since the LLC has a better asset protection potential and can be taxed under any provision of the IRS, an LLC is going to be the entity of choice. But how do you want it to be taxed? You have to tell the IRS how your LLC is going to be taxed.

Generally you will be taxed as a sole proprietorship (one person owner), partnership (more than one owner), or a Subchapter S (one or more owners). You will almost never have a Corporation or LLC taxed under Chapter C. If you have an entity taxed under Chapter C, we need to talk. You had better get me on the phone.

Your choice of taxation will depend upon how your money is being made. If the income is “passive income” or “unearned income” (rents, interest, sale of an asset such as real estate, etc.), you will want your taxation to be either a sole proprietorship or partnership, because the income will “pass through” to the owner(s) without any social taxes (self-employment or withholding taxes).

If the income is “earned income” or “active income” (income generated by the sale of goods or services), you will want your taxation to be under Subchapter S. Under an S taxation structure, you can take out a “reasonable” salary, and the rest of the income can be paid out as a distribution to the owner(s). The reasonable salary is subject to the social taxes. However, the distribution is not subject to the social taxes. On the distributions, you will save about 16% right off the top, because you won’t have to pay the Social Security, FICA, etc., on the distribution amount. The total amount of earned income paid though a sole proprietorship or partnership tax structure is subject to the 16% social tax.

Remember, the asset protection (corporate shield and charging order) is the same no matter how your LLC is taxed.

The new Trump Tax deduction of 20% of your profit applies to all “pass-through” tax structures. That means an individual or business entity (LLC) taxed as a sole proprietorship (Schedule C or Schedule E), partnership, or a Subchapter S (corporate or LLC structure) will get in on the new tax savings. There are lots of rules, but basically you get 20% of your profit tax free. That’s a nice tax break for the small business. The new Democrat controlled House says they are going to take that away from us. I am not happy with that.

Where to Form Your Entity

Do not fall for the “Got to have your LLC in Wyoming or Nevada or Utah or New Mexico or any place else” SCAM. You should form your corporation or LLC in the state where the entity will be owning real estate or doing business. There is basically no exception to that rule. You could form it in the state where you live and then register it in the state where the entity will own real estate or be doing business, but most commonly, you live in the state where the real estate is or the business is being done.

There is no advantage to having a business entity established in a foreign state, for example Utah. There is a group going around on the real estate circuit promoting Utah LLCs. They charge about $5,000 for three LLCs. This is insane. I live in Utah, and Utah has horrible LLC laws. But that’s not even the issue. You still have to register the LLC in whatever state you are holding real estate in the LLC or where the LLC is doing business. You are then subject to all that state’s laws. You pay tax in that state. You will get served and go to court in that state if there is a lawsuit. You pay all the fees in that state. You don’t really care that Utah has horrible laws, except if the Utah law is worse than the state where you are sued, the guy coming after you will argue that the judge should use Utah law.

Don’t fall for the “Do your LLC here” scam. If you hear someone in a seminar selling an entity in a “special state” the answer from you is NO. Save your money.

Which 2 of the 4 Elements?

There are four elements that define a corporation. They are: limited liability shield, transferability of ownership (stock), continuity of life, and centralized management. In order to distinguish an LLC from a corporation it was agreed that an LLC would only have two of the four elements. Which two do you want to pick, and how do you identify which two you choose?
You will obviously want the limited liability shield. That’s the corporate shield. Your operating agreement will state that the managers and owners have limited liability. Once you pick that one, now you get one of the other three.

You probably don’t want centralized management, because you will always manage the company or one of your “partners” will manage it. It is very unlikely that you will hire someone to manage your LLC who is not an owner of at least part of the LLC. Thus, your operating agreement will state that the LLC is member managed. That means that the LLC will be managed only by members. If you state that the LLC is manager managed, then the management of the LLC is centralized in the managers, not the members (owners). Sometimes the state articles of organization or certificate of organization will ask if the LLC will be member managed or manager managed, but it should always be stated in the operating agreement.

It is unlikely that you will want to trade stock (membership interests) in your LLC, so your operating agreement will somehow restrict the free trading of membership interests. It will say that a membership interest cannot be sold without the approval of a majority of the members or some such restriction on the transfer of membership interests.

That leaves continuity of life. There may be a term (time period) of the LLC stated in the articles of organization filed at the state. That will often be something like 20 years or “perpetual.” The operating agreement will state whether or not the company will survive the death of a member. Somehow the operating agreement will state what happens at the death of a member.

In addition to the liability shield, you get to pick whichever of the remaining three elements you want. If you don’t pick continuity of life, the company can be “reconstituted” after the death of one of the members. The operating agreement should state how that will be done. Remember, your operating agreement can be amended. The operating agreement should state the procedure for amending or restating the operating agreement, but with the power to amend, you can always change your mind.

Getting Assets into Your LLC

Once you get your LLC established, you will start feeding assets into it. You should set up a bank account to hold the LLC money in. To get the business going, you should put money into the bank account. You may also put an asset, such as a piece of real estate into the LLC. If assets are moved into the LLC at the time it is established, the assets will often be listed in the operating agreement and they will “buy” a membership interest in the LLC. That interest and the assets will be listed in the operating agreement.

Obviously, money is moved to the LLC by simply depositing it into the bank account. Real estate needs to be deeded into the name of the LLC. Use a warranty deed, so the warranties move with the property to the LLC. A quitclaim deed will not transfer warranties, such as title insurance.

If money or assets are transferred by you later after the LLC is originally established, the assets may not be listed on the operating agreement. Rather, the value of the movement of cash or property into the LLC should be reflected in the contributor’s “capital account.”

Sometimes a member’s ownership in an LLC or a stockholder’s stock in a corporation is “earned” by what we call sweat equity. You have to be careful with sweat equity because the value of the ownership earned is considered income for income tax purposes. More or less, if Joe puts in a $300,000 rental unit for 50% of the membership interests, and his son gets 50% of the interests because he rehabs the unit, the IRS will say the son got $300,000 in income. Of course, no money is transferred to pay for the sweat equity, yet the IRS will attribute income and charge a tax. So be aware of that trap.

The Holding Company

It isn’t unusual to have a couple of LLCs owned by a centralized holding company. In fact, it is a trick of the real estate seminar speakers who line up LLCs for you. They say that you should have a Nevada or Wyoming LLC or corporation established to hold all of your other LLCs. They claim that there is better asset protection with this structure. There is no question that you, as an individual, are one step removed from having someone come after you and pierce the corporate veil of one of the LLCs.

However, if the corporate shield can be pierced in one of your LLCs or corporations, it is pretty much guaranteed that you are doing something wrong with your entity. You may be commingling money or doing something that will allow someone to pierce your corporate veil. You are probably doing the same thing wrong with each of your entities, so they will all fall like dominoes.

There is a total disaster brewing for people who set up LLCs or corporations and then have a corporate holding company. It doesn’t matter where the holding company is formed. As soon as you get a personal judgment against you, the creditor can take the stock in the holding company. Once the holding company stock is gone, your creditor “owns” all of the assets associated with the holding company. That includes all of the LLCs that the holding company owns. The concept of charging order protection doesn’t apply to the holding company corporation.

Basically, a holding company is never a good idea. The object in asset protection is to break the “causal connection” links between entities and properties. A holding company ties everything together rather than separating ownership. You really want to separate ownership so that if one rental unit goes underwater, the other units in separate entities (ownership) can’t be attacked. If the holding company can be attacked, then all of the LLCs are at risk.

Conclusion

Business entities are valuable asset protection and tax tools. An LLC is the most flexible type of business entity we have. People who promote LLCs or any other type of entity are simply trying to sell you the entity. The more entities they can sell, the better for them. You may not even need an entity. The vast majority of entities established in another state as part of a package deal are never used and the money (your money) is wasted. Make sure the entity is properly established and funded.