Follow Us on Social Media

email icon rss icon linked.in icon google plus icon twitter icon facebook icon

Are You Making This Common Entity Mistake?

by Amanda Han on March 7, 2014 · 19 comments

  
Common Entity Mistake

Meeting with clients this time of the year is great for my Bigger Pockets writing….it creates lots of real life situations that I can share with you guys on things to look out for and mistakes to stay away from. Today I wanted to talk about legal entity mistakes. I am not an attorney so I do not have the credentials to provide you with legal advice. In fact, my legal opinion is probably worth about a dollar, if that. Nonetheless I would still like to share these common errors that I see with you and I would love to also hear some comments from attorneys in our Bigger Pockets community as well.

Here is the Common Scenario:

A client walks in with their tax information and tells me they have formed a few legal entities. Company A was formed to hold rental property on Main Street. Company B was formed to hold property on Harbor Street.  Company C was formed for some fix and flip that they were planning on doing.  And last but not least Company D was formed to be the holding company of all of these entities. My first question is generally: Great, tell me how the new entities have been working out for you?

Inevitably, there will be the client who turns red and then tell me that they have actually not used any of these entities that were created. Rental properties are still held by their personal names, rent checks still being made to their personal accounts. What about the game plan for that lucrative fix and flip business? Well, it was hard to get a property under contract so no deals have actually been done in the entity just yet.

Related: C Corporation: The Active Real Estate Investor’s Preferred Choice of Entity

Reality Check…

This means that I, as the tax advisor, have to be the bearer of bad news and give them a reality check. Essentially, what has happened is that the client has incurred a lot of costs (i.e.: legal fees, state fees, etc.) and time to form these legal entities that they are not getting any benefit for. Why would someone go through all the trouble of forming entities for asset protection and tax write offs but then never actually use the entities? I can’t answer that question myself….but I can say that this scenario applies to a lot of people that I meet with.  So, if what I described above sounds eerily like you, don’t feel too bad because you are not alone.

My guess as to why this happens is that I think maybe some investors have a false sense of security in that they think by simply paying an attorney to form a legal entity that somehow they magically get asset protection. Well….this is definitely not the case. Based on my experience, owning a legal entity alone provides you with no real asset protection. You actually need to be utilizing the entity correctly and in the way that you attorney intended for you to use it before you get any real asset protection.

The minimum to be done is to at least transfer your property into the entity. Title should definitely be transferred out of your personal name if you want to protect your personal assets from potential lawsuits.

You will also want to makes sure you set up a company bank account for your entity so that the account can be used to receive income and pay expenses with.  This way you can show that the entity is distinct and separate from you. Another great benefit of having an entity bank account is that it makes things a heck of a lot easier for you at tax time. If you have ever paid your real estate expenses from your personal bank accounts, you know what I am referring to when I talk about the pain and time needed for you to break out the real estate expenses from your personal bank account at tax time. This is something that can easily be avoided if you have an entity bank account to pay for all your real estate related expenses.

Related: What Type of Legal Entity Should I Hold my Real Estate In?

Furthermore…

Having separate bank accounts can help you tremendously for audit protection purposes. IRS generally puts more weight to something being a business expense if it is paid out of a legitimate operating legal entity rather than out of your personal bank account.

Now what about that entity you formed last year for your planned fix and flip business? Well, I would definitely ask yourself the question: Do I plan on flipping properties this year? If the answer is yes, then start using that entity for all your flip related income and expenses. If the answer is no, then now is a good time to visit with your CPA to strategize on what the best thing is to do with that entity. For example, are there other ways we can use this entity to save taxes or minimize liability exposure? Or is it simply better to just dissolve the entity and minimize costs of an entity that is no longer needed.

Another common myth that I see is that people often think that because a legal entity was not used, there are no taxes to be filed. That is definitely incorrect. Yes, it is possible that in certain instances, you would not be required to file a tax return if no business was done in the entity. However, most of the time tax returns are required even for entities with no activities. Whether a tax return needs to be filed for an entity or not will depend on the state you live in, the state the entity is formed in, as well as who the owners are. The IRS imposes hefty penalties for entities that don’t file the required tax returns and so do a lot of the states. So if you have formed an entity but had no activities within them, be sure to let your CPA know about these entities so they can help you strategize accordingly.

Have any of you had an experience like this? Let’s discuss! 

Email *
  



{ 19 comments… read them below or add one }

Adrian Tilley March 7, 2014 at 11:48 am

Great article Amanda. I would add that many times entities do not provide the legal protection that people think they do. Simply having a shell of a company with no (or minimal) assets, no insurance, etc. can get the owner into a lot of trouble. Also, individuals could be held liable for their individual actions, even when taken on behalf of a company.

Reply

Amanda Han March 7, 2014 at 12:36 pm

Great comment Adrian. Thanks!

Reply

Lisa Phillips March 7, 2014 at 12:26 pm

Hi Amanda, great article and quick question: Its still okay according to the IRS and liability wise if you have an LLC with a separate banks account, operating agreement, insurance, etc, but you do not title it in the LLC’s name? Or, do you feel with the IRS that is fine, but for liability it is not? Thanks again for another great article!

Reply

Amanda Han March 7, 2014 at 12:38 pm

Hi Lisa:

I personally have never had an IRS audit the title of the property to be an issue…but that doesn’t mean that they can’t make that argument. My suggestion is to have use it correctly as that is what is best both from an IRS and legal perspective. So yes…re-title the property into the LLC to get the best advantages. I have seen IRS disallow income being attributed to an entity when a 1099 is issued in a person’s name so definitely make sure that this is done correctly as well.

Reply

Walt Payne March 7, 2014 at 2:27 pm

Be careful about re-issuing a title. I’m not saying don’t do it, but ask professional advice on all of the pitfalls. Transfer taxes, property tax assessments, loan issues, insurance issues … lots of considerations. All can be dealt with, but you don’t want to find out after the fact that you forgot something. Most will work with you to do it seamlessly if you approach them before the fact. But you don’t want to try to reverse a tax bill after the fact, or re-instate cancelled insurance, or deal with a loan called due because of a “sale” or transfer of the property.

Reply

Brett Synicky March 7, 2014 at 2:20 pm

Hi Amanda,

Do you recommend having 1 entity per property or placing multiple properties in multiple entities? For example, say I have 12 properties. Does it make sense to have 12 different LLC’s with 1 property in each or have say 4 LLC’s with 3 properties in each? Obviously there’s a cost difference to the two approaches but what about asset protection?

Btw, Love your blogposts!

Reply

Amanda Han March 7, 2014 at 3:52 pm

Hi Brett:

it ultimately depends on your risk tolerance level and the cost benefit of having multiples. Here is CA for example our cost of having entities are very high so we rarely suggest the one property per entity approach undre normal circumstances. It ultimately comes down to the risk exposure of each of your properties as well as the equity you have…that way you can find a happy medium to balance the cost and the asset protection.

Reply

Steve March 7, 2014 at 3:16 pm

Hi Amanda, I started out down the road of a LLC for each property for liability purposes, but have now transitioned to an umbrella policy to cover them all after I began to understand than an LLC may not provide much protection. More to the point of your article, I have always filed an individual tax return which includes my LLC income, as that passes to the individual. It think I have been doing this correctly, but could you clarify your comment regarding entities and tax returns, perhaps specifying between LLC’s v. S Corps?

Reply

Amanda Han March 7, 2014 at 3:53 pm

Steve:

Yes if you are the sole owner of the LLC then the LLC is not required to file Federal income tax returns and can be reported directly on your personal return. Corporations (C or S) on the other hand always require federal income tax returns so that is a cost that you need to factor in if you are considering a corporation for your business.

Reply

Sharon Tzib March 8, 2014 at 7:40 am

Man, I see this all the time on the forums – people setting up LLC’s before they’ve even done a deal. A lot of them do it also because they think they will get more tax write offs having an LLC, which as you stated in your podcast, is not true.

Too many people put the cart before the horse. Buy some real estate first, for cryin out loud. Then decide if you need an LLC. Unless you’re in a partnership or are a high net worth individual, I’m with Steve – a good umbrella policy suits me just fine.

I used to live in Calif, and regardless of where I owned property, if I wanted an LLC in another state, I also had to have one in Cali, which cost me $800/year plus CPA fees for annual tax filing. The costs can add up realllllllll quick!

Reply

Amanda Han March 10, 2014 at 11:43 am

Yes…that is very unfortunate and CA has been getting more aggressive with their collection of the $800 fees. I wrote another post on the changes in CA entities recently on bigger pockets that specifically addressed the CA issues.

Reply

Eric March 8, 2014 at 11:55 am

Thanks Amanda! Wish I had read this 2 years ago. Instead learned the hard way to not start my LLC until I actually had assets to protect. It is not too expensive in Oregon as long as you’re sole member – found out the hard way that having my wife in it as well costs an additional $150/year tax in OR regardless of activity.

Reply

Amanda Han March 10, 2014 at 11:44 am

Thanks Eric…better late than never! Now pass on what you learned from your experience to help other investors avoid this mistake.

Reply

Lear Riojas March 10, 2014 at 1:02 am

My question concerning entities is, if you create an LLC and place your properties into it, albeit based on what I have read, the bank will require a personal guarantee, will those mortgages come off of your credit report?

Reply

Sharon Tzib March 10, 2014 at 8:22 am

Most banks will not fund a loan in your LLC’s name, unless you are an experienced investor with a track record. Normally, the loan stays in your name and the title gets transferred to the LLC.

Reply

Amanda Han March 10, 2014 at 11:46 am

Hi Lear!!
It will depend on the bank but yes a lot of banks may not lend to LLCs unless if that LLC is established with years of profitability and or assets to back up the loan. I do believe that any issues will impact your personal credit provided you give a personal guarantee. What I see most commonly is that you can simply transfer title from the LLC back into your personal name before you get a loan or refi and once that is done to transfer it back to the LLC.

Reply

Shaun March 10, 2014 at 7:54 am

Certainly a problem that can hit anyone at times.
I was one of those newbies that got something in place but didn’t use it for awhile.
Pretty much sat there for a year or so. Heavy use since but jumped the gun.

Have one new unused one this year.
Hit my comfort limit for units in the one I was buying in for an area, so formed a new one but then didn’t make another purchase there this year.
It’ll be used but wish I had waited a few months to do it now.

Reply

Amanda Han March 10, 2014 at 11:47 am

If you ever find yourself sitting very close to the end of a year (say November or December) and you are unsure whether you will use an entity…it generally makes sense to hold off until you know for sure. That way if a deal does not come through then you at least save on entity costs for that year.

Reply

Shaun March 10, 2014 at 12:03 pm

Wasn’t quite that foolish.
It was in June I believe, and had a property that I was going to put into it.
Didn’t get it all finished quite fast enough and didn’t want to delay the close so bought it with the existing one but then didn’t buy anything else in that state the rest of the year.

Reply

Leave a Comment

Comment Policy:

• Use your real name and only your name in the field designated for your name.
• No keywords allowed as anchor text in the name or comment fields.
• No signature links allowed under your comments
• You may use links in the body of your comment, but it must be relevant to the discussion at hand, and not merely be some promotional link.
• We will have NO reservations about deleting your content if we feel you are posting merely to get a link without adding value to our discussion.
If you add value, but still post keywords, we'll use your comment, but remove your link and keywords.
• For more information about acceptable practice, see our site rules.

Want your photo to appear next to your comments? Set up your Gravatar today.

Previous post:

Next post: