The TRUTH* about entity protection

SHOULD YOU HAVE AN ENTITY?

There is a lot of discussion on the forms regarding whether to use a business entity for real estate investing, and if so, which entity to use. People discuss options such as C Corporations, S Corporations, LLCs, LLCs taxed as an S Corporation, Partnerships, sole proprietorships, or just doing everything in your own name.

These are all valid options, and any one might be the right fit for a particular person or business model. Some investing methods carry vastly more risk than others (think bird-dogging vs building from the ground up). To get a good handle on which is right for you, you need to talk with a CPA and potentially an attorney in your area. The CPA can inform you about the tax consequences of using a particular entity (or none at all) and the attorney can help you set one up properly. Making sure the entity is set up correctly is particularly important. It can have a big impact on whether your entity will do what you want it to do - I'll discuss this below in connection with piercing the corporate veil. The goal of this article is to provide some basic information about the level of liability protection provided by a business entity.

YOU ARE NOT AS PROTECTED AS YOU THINK...

Many believe that once you have a business entity, anything you do in or as part of that business is protected, and a third party can only sue the business for an wrongdoings they perceive. Many people are not aware that generally (at least in my state) a person can be sued individually for his or her individual negligence even if he or she is acting in the course and scope of his or her employment.** So, if you are replacing wiring in a flip, and the wiring job is bad and burns the house down after you sell it, the new buyer can sue you personally for your negligence in failing to properly wire the house. The entity can be completely disregarded, and all of your assets are on the line, not just business assets. This includes your personal house, property, cars, your income from your J.O.B. can be garnished, your interest in other businesses can be pursued, etc. As an example, if the CEO of Home Depot is carrying bricks through the store for some PR photo (I have no idea if this happens), and he drops the brick on my foot, I can sue him personally (cha-ching!).***

"Ah ha!" you say, "I don't do that stuff - it's beneath me" (except for B. Turner - go get 'em dude!). "I hire an independent contractor to do that for me!" This may provide you some protection. Generally, an independent contractor is liable for his or her own work, and you aren't. There may be a claim against you for negligent hiring if, say, you found someone with no electrical training or experience and had him or her wire the whole house for $8/hour (basically, if you were negligent in hiring the right person for the job).

But the same protections apply even if you have no business entity. So, if everything is in your name, and you hire an independent contractor and her or she messes something up, you have the same level of protection as if you had an entity in place.

THE KNIGHT AND THE LANCE (or, piercing the corporate veil)

Okay, I got this analogy from Bill Gulley, who posted a great description of this concept on the forums. The requirements vary from state to state, but here's a basic description. The corporate "veil" is the liability protection that a business entity generally provides. That veil can be "pierced", allowing liability on individual shareholders, if certain requirements are met. This generally happens when a Court determines that the business entity is the "alter ego" of the owner. There are a variety of factors that come into play, which in Colorado include:

1. whether the corporation is operated as a distinct business entity
2. comingling (mixing) of funds and assets between personal and business accounts
3. whether adequate corporate records are maintained
4. thin capitalization
5. whether the corporation is being used as a "mere shell"
6. disregarding of legal formalities
7. entity funds/assets used for non-business purposes

Remember how I said above that the business had to be formed correctly? Take a look at factor 6. If you don't have the right documents in place, don't hold shareholder meetings regularly, etc, the Court might decide you don't have a "real business".

The "thin capitalization" factor can also be a big one. If your business has $5 in the bank, you can't hide behind the veil the entity would otherwise provide. Even if your funds are low, having other assets or adequate liability insurance may help.

SO THERE'S NO REASON TO EVER HAVE AN ENTITY, RIGHT?

Um, no, that's not right. There may be (and probably are) a variety of tax reasons to have an entity - consult a CPA. Additionally, businesses do provide some liability protection, assuming you follow the correct procedures.

Personally, I created an LLC as soon as I decided to start investing. I knew I was going to do it sooner or later, and in Colorado it only costs $50 for the filing fee. Even though it may not currently provide all the protections it eventually might, I'm in this for the long haul. Contrary to some advice on the forums/podcasts, I'm creating my business cards, letterhead, website, etc while getting my marketing up and running. I'm going to do it all, so I might as well do it now!

If you have any questions or thoughts, please post them below, but keep in mind that I will not of course, provide any legal advice. =)

*Well, my version of some of the truth anyway. Keep in mind that although I'm an attorney, this is not legal advice, and I don't represent you. Laws vary from state to state. This information is provided to get you thinking - if you have questions or concerns, take them to a qualified attorney in your area.

**Many times, if an employee is acting in the course and scope of his or her employment, the employer can also be held liable. Be careful who you hire!

***The case that permits this in Colorado is Hoang v. Arbess, 80 P.3d 863 (Colo.App. 2003). I haven't done any research to see if there are similar cases in other states.