Forming your LLC

21 Replies

New Investor who will be purchasing their first multi-unit (2-4) this year. I had a question about my LLC. A little about my situation, I live in Denver but will be investing out of state in Dallas/Ft. Worth due to a number of factors. I have multiple questions about forming my LLC:

1.) Create in state I live or state I'll be investing in (CO vs TX)?

and

2.) Since I am starting out small do I need to get a Real Estate Attorney to help form my LLC or is it as easy as going to the local county clerk or wherever and giving them the $25ish to form it? I know in CO you can actually do everything online through the secretary of state website. Also, can you restructure an LLC later as my business grows for better asset protection or just create more.

I'm no business formation attorney, but I'll take a shot at #2.  You don't "need" an attorney, especially just for formation.  However, depending on why you want an entity, you might need one.  One purpose is asset/lawsuit protection.  For that to work, you need to make sure it's seen as a "real" business and not just a shell.  That means an operating agreement, etc, as well as insurance, bank accounts, etc.  If it's just an empty filing, the Court may find that it's a sham.  Hope that helps.

One thing I would suggest is getting any kind of loan in LLC's is challenging and the mortgage lenders who offer financing on LLC are very limited. You will find lot of options if property is under individual's name.

As a fellow newbie, I would offer this advice. Hold off on forming the LLC until you get a few properties that you intend to hold. The biggest reason for forming an LLC is Liability protection. You can go to your local insurance agent and buy an umbrella policy fairly cheap that will cover you until you get a portfolio large enough to warrant the protection of the LLC. Just 2 cents from another novice investor ;)

@Christopher Beale   @Adrian Tilley   @Nilesh Makhija  

Thanks guys for the sound advice, I appreciate it! I think I'll hold off for now for the reasons you guys mentioned and I can just have a bunch of clauses in tenant application forms to limit the possibility of getting sued, which is probably one of my bigger concerns for starting out.

Regarding number 1, most states require you to register as a "foreign entity" to do business in the state. In MD for example you have to register an LLC formed in another state and pay a $300 a year fee (the same as an in state company)

An LLC won't provide much liability protection if the business is not established and run correctly. It is true about the difficulty with many lenders about recording properties in the name of the LLC. Also, costs and procedures to establish and maintain an LLC differ greatly from state to state. In some states it is quite costly, in others not much at all.

We run our business under two LLCs.  We do it for business reasons, not liability protection reasons.  We had a top notch business attorney set them up because we have two family partnerships and needed the LLCs for defining our business practices and for determining the course of action if one of the parties should want to sell out or died.  For liability protection, we have a good landlord policy in place on each building and we have a $1M umbrella policy.

the Colorado Secretary of state declared a business formation fee holiday beginning July 1, so right now forming a Colorado LLC costs only 1.00 in state fees. Not sure how long the holiday will last, but you can save a little money while it does.

Unless you have a lot of money your worried about protecting, or a situation like @Marcia Maynard don't run out and form an LLC thinking it will save you, and you can put any clauses you want in your lease, if someone wants to sue you they can, and if they have a valid reason for suing you, they could win.

Get a good umbrella policy, at least $1 million, and manage the property properly,,the insurance will provide your defense if someone does sue you.

I always put it this way, if your tenant tells you they smell gas and you do nothing, they tell you again that a few days later, you do nothing, and the house blows up and hurts someone, your in trouble, I don't care if you have an LLC, series LLC, 19 different shell corporations etc,,,you didn't take action to resolve the situation and will be held personally liable (after all you were the one that didn't take action). Manage your property effectively, be especially careful in the area of safety, use common sense, and have a lot of liability insurance.

Originally posted by @Ryan Dickinson:

the Colorado Secretary of state declared a business formation fee holiday beginning July 1, so right now forming a Colorado LLC costs only 1.00 in state fees. Not sure how long the holiday will last, but you can save a little money while it does.

 Thanks for the heads up Ryan, time to stock up!

Originally posted by @Ryan Dickinson:

the Colorado Secretary of state declared a business formation fee holiday beginning July 1, so right now forming a Colorado LLC costs only 1.00 in state fees. Not sure how long the holiday will last, but you can save a little money while it does.

I noticed that while on there forming a new LLC for a property I'm buying. Time to stock up, indeed!

Forming an LLC is very important for liability protection. You probably don't need to start forming any LLCs until you actually have some property, but it is best to form a separate LLC for each property and then form a separate LLC for your holding company. Definitely form the LLC when you get close to closing on the property, and have the LLC actually close on the property rather than closing on it under your own name. Make sure to draft your purchase and sale agreements to they allow you to assign your interest to a related entity before closing.

The reason for forming separate LLCs for each entity is that your liability is limited to your investment in each one. Getting insurance is very important, but let's imagine that you have $1mm of insurance on a property and someone is injured on the property and wins a claim for $2mm. If the property is not in an LLC, the plaintiff can come after you for the portion of the award not covered by insurance. If there is an LLC then you are protected in most cases.

I say "most cases" because an LLC is not a "get off scot-free card." You absolutely must observe corporate formalities, like separate bank accounts, etc. Otherwise, a court might find that the LLC is just a sham to avoid liability and deny you the corporate protection. But if you can't observe the proper corporate formalities, you really should not be in this business, or any business for that matter.

Another reason to have an LLC is if you get involved in partnerships, it becomes much easier to keep your various interests separate. And, again, if you get into a dispute with a partner in a particular LLC, it is much easier to limit the potential liability to that business.

Sometimes the banks will actually require you to own the property through a "special purpose entity" because they don't want it being mingled with other assets. Typically, this SPE is an LLC.

One other thing to note is that, when dealing with banks, unless your business has so many assets and so much cash flow that the banks will feel secure dealing with it alone, you will personally have to guarantee the loans, even if the legal borrower is the LLC. But, again, that fact does not make an LLC worthless. In this case, we are only talking about personal liability in the event of a default on the loan. But your liability is still limited to the LLC when it comes to vendors, partners, and tenants.

If you are going to do this professionally, for a living, it is very important to think about your potential liability, especially when it is multiplied because you own several properties.

Hope this helps.

Oh, by the way, don't "stock up" on LLC's you don't need. LLCs often have to pay business taxes and need to file tax returns, even if they have not done business. It varies from state to state. Why do you think the state is offering LLC's for $1? They hope to make money in fees on the back end!

Originally posted by @Jonathan Twombly:

Oh, by the way, don't "stock up" on LLC's you don't need. LLCs often have to pay business taxes and need to file tax returns, even if they have not done business. It varies from state to state. Why do you think the state is offering LLC's for $1? They hope to make money in fees on the back end!

 As long as you file on time and file online the fee in CO is $10 for your annual report.  No further filings or taxes required.

Originally posted by @Jon Holdman:
Originally posted by @Jonathan Twombly:

Oh, by the way, don't "stock up" on LLC's you don't need. LLCs often have to pay business taxes and need to file tax returns, even if they have not done business. It varies from state to state. Why do you think the state is offering LLC's for $1? They hope to make money in fees on the back end!

 As long as you file on time and file online the fee in CO is $10 for your annual report.  No further filings or taxes required.

 Jon is correct.  Also, with respect to the "protection" part of entities, it's complicated, and will frequently fail in small businesses where you are the only employee.  I wrote an article about it here

@Adrian Tilley Adrian, very good article. Obviously, there are ways to defeat an LLC, which is why I emphasized that it's important to observe all the corporate formalities, as you point out in your article. Piercing the corporate veil is always a possibility, but as you know there is a presumption of limited liability and piercing the corporate veil is not very easy. Of course, if the plaintiff's suit relates to something that you did personally, LLC protection will not avail you much. But if you are operating your property through the normal course of affairs and someone is injured on your property because, say, your handyman does a bad job shoveling the snow in front of your apartment, it will be very hard for anyone to successfully argue that this happened in your personal capacity if you own the property through some corporate entity like an LLC.

@Gary McKissick I didn't read all of the responses, so someone may have already said this. But there's no requirement to have an LLC in the first place. Talk with and attorney, a good insurance agent, and your tax person. There's probably millions of rental properties throughout the USofA that are not held in an entity. That doesn't necessarily make it right, but still, you may find that you don't even want to do an LLC at all.

My understanding is that in Texas you can set ups series LLC that allows you to split subsidiaries very easily but they roll up to a master LLC for tax purposes. I would look into this, I think you can use it to easily put each future property into its own LLC providing even more asset protection. Other states do a similar thing so see if Colorado does this as well.

Series LLC

@Jonathan Twombly    Already explained why LLCs are a good idea for legal protection. 

On the borrowing side, I see a lot of people saying banks won't lend to LLCs. The bigger truth is banks (and other creditors) are not likely to lend to LLC (or any other business entity) with no credit history, track record, etc.

You are likely going to have to make a personal guarantee (along with a down payment) to secure financing when you start out. I.e. you will personally be on the hook to pay off the creditors along with the LLC you formed. Creditors like to wear belts and suspenders to keep their pants up.

 

@Gary McKissick   I will change how I say this, because @Jonathan Twombly has some very valid points. Re using an LLC, either do it right or don't bother. I am not a lawyer, so I don't profit from this. But there is a high probability that if you do the "lawyer in a box" thing, or create an LLC online, that it will be worth something on the order of what that used pile of paper is worth. If you hire a lawyer to create the LLC and instruct you briefly on what you need to do to make it useful, then follow his/her instructions ,,,, you will have a valid asset protection. Yes, it will cost more. But it will be a meaningful step. Otherwise, buy yourself good insurance coverage (which you will need anyway). If you find you need additional LLCs later because you are doing flips, etc, then by all means do it online because you will know the requirements.

You do not necessarily need a lawyer to form an LLC, but I would suggest consulting with one to discuss why you would need one.The value of counsel is not in creating the entity itself, it is in creating the scheme to achieve what it is you want to achieve. To that end, the three most important reasons you may want to create an entity are liability protection, asset protection, and taxation.

Adrian’s article discussed some of the issues involved with the liability aspect of an entity. Namely, you can still be sued for your individual negligence and you can conduct your business in a way that would lead to the corporate veil being pierced.

In terms of asset protection, an LLC may not be the best option if it is a single member LLC. Many states have allowed the creditors of the single member to go after the assets of the LLC itself. This is different from what happens where a multi-member LLC is involved. In such cases the creditor can only go after the member's distributional interest and not the LLC's property.

As far as tax purposes, it is my understanding that the IRS will treat a single member LLC as a sole proprietorship. My suggestion is to consult a professional and discuss these three factors with him or her. Then decide which entity best suits your needs and draft the appropriate documents.

When they sue, and it is a multi-member LLC they will name everyone involve and go after everyone but most Gurus teach you are protected, but you are not. Get a good insurance policy.


Joe Gore

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