BiggerPockets

Choosing And Maintaining The Right Entity Structure

I often get asked: "Is an LLC Preferable to an S Corp for a Real Estate business?"

It depends on your RE strategy. The entity you form should be based on your real estate investing strategy If you are rehabbing, wholesaling or bird dogging you should form an S Corp to help you lower your self- employment tax. It's not a one size fits all in Real estate.

OVERALL ADVICE: START WITH YOUR R.E. STRATEGY AND FIND THE STRUCTURE THAT FITS THE STRATEGY

3 Factors in Choosing the right Entity Structure

• Ease of compliance - What are the compliance requirements - annual filings, fees, separate tax returns, mandatory meetings, etc.

• Tax Liability Reduction - What is my tax exposure based on my real estate or business strategy and how can a specific entity reduce that tax liability.

• Asset Protection - How does this entity protect me from Bottom up and Top down creditors

The goal is to find one that meets all three criteria. One size does not fit all. Structures can be changed.

If you already have an LLC, Is it toxic?
Most LLC's simply do not give you the significant dollar-saving benefits that a well designed and documented LLC should give you.
You may be asking this - "I am only a small operation, do I need all of this?" ??The answer is ABSOLUTELY, even more so because there is this basic rule of entity protection: The smaller the entity, the more the need for such complete documentation!
Your LLC is Toxic if...
• It does not shield you, causing your personal assets to be totally exposed.

• It does not save you in taxes (when it should). Having certain Tax Elections and tax matters in the operating agreement and other LLC documents can generate for you, yearly tax savings you didn't even know about.

• It does not defend you against IRS (when it should). IRS auditors typically examine LLC legal documents to see if they support tax deductions and strategies. If they don't, you are out of deductions and a lot of money

• It does not prevent legal disputes with partners or others (when it should). Having the proper language would do this and save you from costly lawsuits.

• It does not give you important operating guidelines for successfully running your business (when it should). LLC documents (especially the operating agreement) should also be your roadmap to help you implement a profitable real estate business

Toxic LLC's do not properly deal with BOTTOM UP CREDITORS (has a claim and/or gets a judgment against the LLC arising from the acts or omissions of the company rather than from the acts or omissions of a member, manager or employee).

Toxic LLC's do not properly deal with TOP DOWN CREDITORS (gets a judgment against the member because of the member's acts or omissions, rather than the acts or omissions of the LLC, its managers or employees).

Where Do You Go From Here?

YOU NEED TO GET A REAL ESTATE OPERATING AGREEMENT - The operating agreement (OA) is the nuclear LLC document. It is the "heart & soul" of the LLC.

The OA should be the most powerful OA and adaptable in all 50 states, it should be specifically designed for your real estate business so that the LLC's specific business purpose* is clearly defined.

Importance of Having a Specific Business Purpose - Most OA's do not state a specific business purpose. To the contrary, the specific business purpose should be explicitly state to make it legally clear to the members, and if necessary to third parties. I recommend OA (and other LLC documents) that are specifically for LLC's intended business purpose, but also has other advantages such as avoiding the costly tax status of being a dealer.

A Good Operating Agreement should have...

Complete legal protection. Should be very lengthy (at least 100 pages in length) a good OA should contain over 240 legal provisions that cover every legal facet of your real estate investment operations so the LLC is an entity separate and apart from you. That is, the affairs of the LLC are not limited liability protections, therefore making it very difficult for any court to pierce its entity veil. As a result, your personal assets are protected.

Avoid Disputes. Included should be special provisions to help prevent legal disputes with partners and others. You avoid expensive trial lawyers and the courts.

Comprehensive tax-saving provisions. There should be at least 10 Tax Elections go give you favorable tax results that save you money.

One Last thing: KEEPER OR FLIPPER?

Whether it be a keeper or flipper, avoid owning any property as an individual (single proprietor) or as a joint venture (such as tenants-in-common or joint tenants). Reason: While the above types of ownership are simple, they have these significant disadvantages:

1. Legal Side - Personal Liability for debts, obligations and torts. For real estate you could avoid personal liability by holding your properties in an LLC or sometimes in a limited partnership (LP).

2. Tax Side - High Audit Risk. Because they file IRS Schedule E (or Schedule C), individuals and co-tenants are more prone to IRS audits. Schedule C's and Schedule E's are audited the most, while partnerships (IRS Form 1065) are audited less.

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