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Posted over 13 years ago

Common Asset Protection Entity Options for New Investors

The following is a brief business entity description of the most common entities used for Real Estate Investors:

 ·        Sole-Proprietorships.  Sole-proprietorships are very common and popular because they are inexpensive and simple to create.  Unfortunately, there is very little asset protection or tax advantages to this structure.  All debts and liabilities of the business become that of the owners.  Real estate investors using this entity risk losing everything they own in case of a lawsuit and will pay high percentages to the government in the form of taxes.  This approach is not recommended.

·        General Partnerships.  A general partnership is a form of doing business in which 2 or more people, called partners, agree to form a partnership to go into business together and earn a profit and have a fiduciary duty of loyalty and trust to one another.  Partnerships are very similar to sole-proprietorships in both their advantages and disadvantages.  One important difference is to have a well thought out partnership dissolution agreement so if you decide to part ways, everything will end smoother.

·        Limited Liability Corporation.  The LLC is a business entity consisting of one or more persons or entities conducting business for any lawful purpose.  LLCs are relatively quick, easy, and inexpensive to form and provide its members great flexibility.  The biggest difference between an LLC and the SP & GPs is that the members of the LLC are not personally liable for the obligations of the LLC.  The biggest disadvantage of the LLC is that it does not provide the opportunity to save on Self-Employment Tax.   Many investors use LLCs to purchase real estate that they will be holding onto.

 ·        S-Corporation.  An S-Corp is a corporation, LLC, or any other eligible business entity that can make a valid election to be taxed under the Subchapter S of the IRS Code.  Unlike regular corporations, an S-Corp does not pay any corporate income taxes on its profits.  Instead, the individual shareholders pay on their proportionate shares of the S-Corps profits.  Many investors use S-Corps if they are dealing with high dollar amounts for the tax advantages.

 ·        C- Corporation.  C-Corps are generally used by larger businesses with large numbers of employees and is rarely a good vehicle for the smaller business owner.  One of the main reasons for choosing a C-Corp is the ability to raise capital and have numerous shareholders / investors.  One of the biggest benefits is being able to fully deduct all employee health insurance and medical reimbursements.  Second benefit is the ability to go public on the stock market to raise capital.  The biggest disadvantage is the double taxation of both your earnings on the business and personal side.  Also, after the first $50k of profits, you are taxed at a level between 34-39%.  Therefore, most small business owners & investors tend to stay away from this structure.

 ·        Limited Partnerships & Family Limited Partnerships.  Limited Partnerships were designed to allow for multiple ‘limited’ partners to invest in a venture without any personal liability exposure for the operations of the business or actions of the other general partners.  This is a good structure for trying to raise capital since the limited partners are usually just investors seeking investment opportunities with strong ROIs and not looking to have a say in day-to-day operations.  A Family Limited Partnership is basically the same except all the members are family members.

In addition to asset protection and tax savings, you may want to consider how to further reinforce your business through estate planning, such as different types of Trusts.  Used in conjunction with a proper entity, trusts can be very effective for additional layers of asset protection and tax savings.  While creditors may still be able to break through your defense, this additional layer will take time and money for attorneys to break through, and this may discourage those without deep pockets from trying to sue or encourage them to settle.  While there are many types of trusts, the basic concept is quite straightforward. 

Specifically, a trust is a relationship in which a person or entity (known as the trustee) holds legal title to certain property.  The trustee then protects and invests the ‘trust property’ and is bound as a fiduciary to exercise that legal control for the benefit of one or more individuals (beneficiaries) who are entitled to a beneficial interest in trust property.

A good example of a trust that can assist your family with tremendous tax benefits is a revocable trust.  A revocable trust is a trust that can be changed or amended throughout your lifetime.  In regards to asset protection, there really is not any.  The main value of a Revocable Living Trust is not in asset protection; rather the value is in an RLT allowing your trust to avoid probate and distributions to minors or children.  Instead of a Will, a well designed RLT will allow you to greatly minimize taxation when passing property to your heirs!  Unlike a Will, where the IRS takes a ‘snap shot’ of everything you own and taxes you on it, a trust will allow simply eliminate your role from the trust and increase the role of the existing beneficiaries, thus greatly reducing the taxes involved.  How valuable is this in creating a long lasting legacy for your family?!

 


Comments (4)

  1. We have a list of attorneys that we refer all of our clients to so that they can set up their entities properly.


  2. should get people thinking and doing more reasearch


  3. Tom excellent information - in fact I was looking for this type of info for a colleague - thank you.


  4. Tom, this might be one of the most important blog posts on the site. I would recommend even beyond an understanding of the different entity structures is advising new investors to meet with a real estate attorney in their state before buying their first property and starting their empire. That way they can find out what type is best for their investment strategy. We have 5 entities, each serving a different purpose and structed differently from another.