Anyone who has closed on a purchase of real estate knows one simple fact: the legal profession kills a lot of trees. In a typical closing with traditional financing, all of this paperwork may seem excessive, but it is a necessary evil. The multitude of pages is necessary to preserve your rights, the rights of the seller and the rights of the lender. Without the abundance of documentation, the parties are not properly protected. The real estate investor takes this paperwork in stride as part of doing business, since no one is going to enter into a lease option with a handshake. However, most investors don’t realize that just as the lack of a contract will leave them unprotected on an investment, the lack of paperwork for their business entities leaves investors even more vulnerable. Part of doing business when you have formed a corporation, limited partnership or limited liability company (LLC) is to have the necessary documents in place to insure that you are protected from the liabilities of the business, as well as the business being protected from your personal liabilities. You can breathe easy. Although you must have the paperwork in place and maintained, it really isn’t as daunting as it may seem. If push comes to shove, in a lawsuit it will be the paperwork that will help save you every time.
Filing the Business with the Secretary of State is Not Enough
The legal existence of every formal business entity begins with the filing of the business with the Secretary of State. Fortunately, many states have modernized their systems and now allow for online business filings. This allows for you to easily file your Articles of Incorporation, Certificate of Limited Partnership or Articles of Organization or Formation for your LLC. Based upon lack of knowledge, many investors will falsely assume that they have done all that is needed to properly form their business and it is now fully operational. This is not entirely true, as additional documentation is needed to protect all involved. Corporations have bylaws, resolutions, and minutes; limited partnerships have a partnership agreement; LLCs need to have an Operating Agreement to insure the greatest protection. These documents serve as a contract between those involved in the business, which dictates the rights and responsibilities of the parties.
Without these contracts in place, you are really leaving it up to the courts to determine the validity of your business and secondly, if the court decides that the business is a legal entity, if it offers you any protection based upon the state laws. Would you allow a renter to move into your rental property without setting the rate of rent, length of the agreement and outlining actions that would cause a breach of agreement and just hope that the court believes your side of the story if you wanted to evict the tenant for failure to pay rent? I didn’t think so. You shouldn’t put yourself in that position with your business entities.
State laws will dictate the necessary paperwork for your corporations and limited partnerships. Generally, corporations are the most paperwork intensive. Not only are there various documents needed immediately after formation, but corporations normally will need annual internal documentation as well.
After the Articles of Incorporation are filed with the Secretary of State, it is necessary to have an organizational meeting. At the organizational meeting, the shareholders (owners) of the corporation will be listed and the shareholders will nominate and elect the Directors of the corporation. As soon as the initial shareholders meeting is concluded, the Directors need to have a meeting to adopt the Bylaws of the corporation. The Bylaws are the main contract stating how the corporation is to be run and which parties have control within the corporation. The Directors will also nominate and elect the Officers of the corporation. While the Directors deal with broad policy decisions of the corporation, it is the role of the Officers to run the day to day business of the corporation. It is also necessary to adopt resolutions allowing the officers to open bank accounts and to designate signing authority. In addition to these initial meetings, most states require at least one annual meeting of the shareholders and directors in order for the corporation to comply with state requirements.
It sounds like a lot to do, but remember that for the typical investor, it may just be you or you and your spouse involved in the corporation. You shouldn’t have any problem having a shareholders meeting nominating and electing yourselves as the Directors, then having a Directors meeting nominating and electing yourselves as Officers of the corporation on an annual basis. In the vast majority of states, you can have the exact same level of protection within the corporation even if you are the only person involved as the Shareholder, Director and Officer.
The key documentation for the limited partnership is the Partnership Agreement. The Partnership Agreement is extremely important in protecting your limited liability as a passive investor. This contract will outline the rights and duties of the general partner and the passive nature of the limited partners. It is necessary to spell out what management authority the general partner has over the business and most importantly what actions the limited partners can take in the business. The limited partners generally cannot participate in the management of the business but there should be provisions that allow the limited partners the authority to appoint a new general partner and there should be restrictions on the transfer of ownership. If the Partnership Agreement provides that the partnership interests are freely transferable, you may end up becoming a limited partner with another limited partner’s judgment creditor. You will want to structure the agreement so that no partner can transfer his or her interests without the consent of the other partners. By having this simple restriction, the innocent partners will be protected from liability exposure of the other partners.
At face value, the LLC seems to be most simple business for the investor to create but the reality is that it is the most complex business because of the flexibility in how LLCs can be operated. An LLC can be member managed or manager managed. It can be treated as a sole proprietorship for tax purposes if there is only one member; if there are multiple members, the LLC can be taxed as a partnership “S” corporation or “C” corporation. It is this flexibility in management and taxation that creates the necessity of having a proper Operating Agreement for the LLC. If you have elected to have a manager managed LLC for your rental properties, you need to insure that you have a manager managed operating agreement. Otherwise, your passive nature and minimal liability exposure may be lost if the Operating Agreement states that the members control the operation of the business. Of equal importance, having the Operating Agreement contain the necessary tax provisions to match the tax election that you have made with the IRS.
There have been tax court cases where the members of the LLC had severe tax consequences levied upon them because the LLC elected to be taxed as an “S” corporation but the Operating Agreement failed to contain the necessary “S” corporation tax election provisions.
Not only are LLCs flexible in their operations and tax election they are extremely flexible in determining the rights and responsibilities of the members and managers. Almost every state statute governing LLCs contains the caveat unless the Operating Agreement states otherwise. What this means is that the LLC can either intentionally or inadvertently elect to have less protection than the state laws allow. Most states do not require LLCs to have annual meetings, thus offering the members the protection without all of the necessary paperwork, unless the Operating Agreement states otherwise.
I have reviewed many Operating Agreements where the owners had absolutely no idea that the Operating Agreement required them to appoint officers and have annual meetings just like corporations. Since they had not been following the formalities of the Operating Agreements, the protection they thought they had could have been lost if a lawsuit had developed. One final note is that since the majority of you are focusing on real estate activities, you need to have provisions in your Operating Agreements dealing with real estate issues. I would not put much faith in an Operating Agreement picked up at Office Depot that consists of eight pages, as some investors choose to buy, to have all of the necessary real estate, management and tax provisions necessary for the proper operation of your business.
Ignorance of the Law is No Excuse
Judges have no patience for business owners that do not properly maintain or create the necessary paperwork for the operation and maintenance of their businesses. When you create your business, you are seeking the protection that the state laws provide for formal business entities. In order to receive those protections, the business has to follow the formalities set forth in the state statutes or the operating documents of their businesses.
There is an old saying in the legal system that ignorance of the law is no excuse. This is the tact that judges will take if you seek protection but you have failed to follow the formalities because you didn’t know what was required to run and maintain the business from a legal standpoint. The legal documentation that governs your business entities is just as important as the legal documentation that you need to protect yourself when you enter into an investment. If you are not willing to take a leap of faith and hope that the court will protect you if you have no documentation on an investment, why would you think that the court would protect you if your business lacks its necessary documentation?