Which is the Best Business Structure for Real Estate Investors?

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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.

Corporations

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.

Limited Partnerships

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.

LLCs

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?

About Author

Greg is a licensed attorney and nationally recognized public speaker focusing on the topics of business formation, estate planning and retirement planning strategies.

35 Comments

  1. David,

    There are certain transactions that it is better from a tax perspective to either have a corporation or an LLC taxed as corporation. The prime example is wholesaling properties. There is no doubt that corporations generally require more paperwork. However, whether or not a corporation is more expensive really depends on the state. There are several states that charge several hundred dollars more to maintain an LLC as opposed to a corporation.

  2. Many on the BP forums and who have been in the REI business for sometime advocating and opting for a beefy insurance policy ($500,000 -$1M) as oppose to creating an entity. What is your take on it?

  3. The California LLC fee hits $6800 when you break a million dollars in sales (not profit, your business can lose money but you still pay $6,800).

    It seems ridiculous that they would charge me so much for selling about 5 houses. We should change our nickname from the Sunshine State to the We Hate Businesses State.

  4. Still no answer on “what is the best structure for an real estate investor??!! Somebody please address this ASAP. People with experience need to jump in here and give some trial and error stories with solutions. Investors with knowledge please give your educated opinion. What is the “best” structure for a real estate investment business ?

    1.C Corp
    2.S Corp
    3.LLC

    • Understanding corporation types – Forming a corporation (C corporation, S corporation) or LLC
      To incorporate your business as a C corporation, S corporation or LLC, formation documents—Articles of Incorporation for corporations and Articles of Organization for LLCs—must be filed with the appropriate state agency. Incorporating helps protect personal assets, while sole proprietorships and partnerships that use a DBA incur unlimited liability.

      To formalize your organization, first learn about and decide which business type is right for you.

      C corporation
      A corporation is a separate legal entity set up under state law that protects owner (shareholder) assets from creditor claims. Incorporating your business automatically makes you a regular, or “C” corporation. A C corporation (or C corp) is a separate taxpayer, with income and expenses taxed to the corporation and not owners. If corporate profits are then distributed to owners as dividends, owners must pay personal income tax on the distribution, creating “double taxation” (profits are taxed first at the corporate level and again at the personal level as dividends). Many small businesses do not opt for C corporations because of this tax feature.

      A C corporation might be the right business type for you if you:

      May need venture capital for financing
      Want flexible profit-sharing among owners
      Want company earnings to stay in your business so that it can grow
      Want flexibility to spread the business earnings between the corporation and shareholders for tax-planning purposes
      Want flexibility to set salaries for employees/owners to minimize Social Security and Medicare taxes
      Want flexibility to provide (through the corporation) substantial health and medical benefits and other fringe benefit programs for things like education, life insurance, and transportation costs
      Want to be able to easily sell your business
      Want to provide an accountable plan for travel & entertainment
      Want to be able to offer stock options to employees
      Expect your business to own real estate
      Prefer to lower your risk of IRS audit exposure, since there is a higher audit rate for business income that is reported solely on Schedule C of Form 1040 (U.S. Individual Income Tax Return)
      Learn More About C Corp

      S corporation
      Once you’ve incorporated, you can elect S corporation status by filing a form with the IRS and with your state, if applicable, so that profits, losses and other tax items pass through the corporation to you and are reported on your personal tax return (the S corporation does not pay tax).

      An S corporation might be the right business type for you if:

      You want to take advantage of benefits that the corporate business type holds, but you want to take advantage of pass-through taxation
      You want flexibility to set salaries for employee/owners to minimize Social Security and Medicare taxes
      Flexibility of accounting methods is desired, because corporations must use the accrual method of accounting unless they are considered to be a small corporation (with gross receipts of $5,000,000 or less) and S corporations typically don’t have to use the accrual method unless they have inventory
      Lower risk of IRS audit exposure is desired, because S corporations file an informational tax return (Form 1120 S U.S. Income Tax Return for an S Corporation) and there is a higher audit rate for business income that is reported solely on Schedule C of Form 1040 (U.S. Individual Income Tax Return)
      Learn More About S Corp

      Limited liability company (LLC)
      Another business type that is formed under state law and gives you personal liability protection is the LLC. Tax-wise, an LLC is similar to an S corporation (or S corp), with business income and expenses reported on your personal tax return. If you are the only owner of an LLC, you are viewed as a “disregarded” entity. This means you report the LLC’s income and expenses on Schedule C of Form 1040?the same schedule used by sole proprietors.An LLC might be the right type of business for you if:

      Your startup company anticipates losses for at least two years and you want to be able to pass the losses through to yourself and the other owners
      Flexibility for accounting methods is desired, because LLCs are not required to use the accrual method of accounting as C corporations typically are
      Your business may own real estate
      You want management flexibility, since LLCs offer more flexibility than corporations in terms of how the management of the business is structured
      You wish to minimize ongoing formalities; unlike corporations, which are required to hold annual meetings of directors and shareholders and keep detailed documents and records for all corporate meetings and major business decisions, LLCs do not face strict ongoing meeting and documentation requirements
      You want flexibility for sharing profits among owners
      Learn More About LLC

      Advantages & limitations of a C Corp, S Corp, and LLC
      C corporations, S corporations and LLCs provide you with personal liability protection. S corporations and LLCs are commonly used for small business activities. Both enable you to grow your business and take on new owners. Both pass through income to owners who report it on their personal returns. Both cost about the same to set up, depending on the filing and ongoing fees imposed by the state in which you incorporate. One key difference is how owners are affected by employment taxes:

      S corporation shareholders are employees of their corporation so Social Security and Medicare (FICA) taxes apply to compensation they receive, but not to distributions they receive.
      LLC members are self-employed individuals who owe Social Security and Medicare taxes, paid by self-employment tax on their share of business net income. Incorporating or forming an LLC provides advantages to business owners that operating a business as a sole proprietorship or general partnership does not, including:
      Limited liability protection for the personal assets of the owner(s).
      Certain tax advantages such as tax deductions not available to sole proprietors.
      Opportunity to gain credibility with potential customers, vendors, partners, and employees.
      Capital can be raised more easily.
      Incorporation Options

      Other considerations: state selection
      Most people opt to incorporate or form an LLC in the state in which their business operates. However, you are not required to do so; you can choose from any one of the 50 states or the District of Columbia (DC). You may want to consider which state is right for you to weigh any potential advantages or disadvantages. Remember, if you incorporate in a state other than the state where you operate your business, you may be required to register to transact business (foreign qualify) in the state where you operate, which results in paying registration and ongoing fees/taxes to both the state of incorporation and state of qualification.

      Making your decision
      The decision to file a DBA or form a corporation or LLC depends on your particular business, situation and goals. Existing corporations and LLCs evaluating whether to file a DBA may need to consider:

      Does the new name project a business focus that is allowed under the business purpose (as outlined in your Articles of Incorporation or Organization)?
      Are there advantages to creating a subsidiary or an entirely new business to operate alongside your existing business?
      For questions regarding your specific situation, consider talking with an attorney or accountant.

      As you decide which business structure is best for you, try our Incorporation Wizard to compare multiple business types by multiple key considerations.

  5. Greg,

    I’ve read a few articles on business structure and for the most part it seems as depending on one’s standpoint: who is your current team, how experienced, willingness to collaborate that would be some factors to consider when choosing a business structure.

    However, My question to you is, If you dont have faith in purchasing an Operating Agreement from a store, How do you propose one is obtained? Make one from scratch?

    Alisha

  6. James (Michael) Ezzell

    just had an after thought. this may sound stupid not sure. but if ones was planning on or has several props the are using for rentals. is a different LLC needed for each prop. to protect them from each other in case of a Law suite.

    • Chris Kelso

      It isn’t stupid James. It is actually a great thought and i’ll explain to you why. When you acquire an asset personally, and something goes wrong, the tenant can sue you. This means all of your personal property are up for grabs in a lawsuit. By putting that asset under an LLC you protect your personal belongings from being collateral in a lawsuit. The same principle applies by having multiple LLC’s. If you put every asset under its own LLC, you are protecting all of your assets from being collateral in lawsuits from the others. Think of an LLC as a force field for each asset you own. If tenant A under LLC A sues you, they can only get whatever is in LLC A. Meanwhile LLC X, LLC Y, and LLC Z are completely protected and not in the equation. Hope this helps.

      • The argument here of other investors is that you don’t have to have an LLC you can umbrella your insurance for $3000000 the word is it isn’t likely that someone is going to get to sue you for near that here in Virginia and it probably applies anywhere else ( make sure you do your research on the insurance company’s some charge a whole lot more than others) also here in Virginia if you have a double wide that is not on a foundation and not a structured home the insurance companies will not umbrella your passive income property therefore you have to find the right insurance company that will allow you to Umbrella off of one of your structured passive income properties and then there are some that force you to do an individual insurance on each one and that becomes extremely expensive I do not have an identity form but now that I have reached 7 units which could be a house or a couple of apartments I am thinking I need to form a business identity especially since I am getting ready to move into wholesale flips. I don’t exactly understand how the different business forms work I was thinking of doing an LLC for protection but my son says I would have better protection if I did an S corp because I am a sole identity I would just have to make sure I did my quarterly taxes and show payment to myself once or twice a year from the company. all of this is confusing to me.

  7. The challenge is that even if you set up an LLC, if you need to finance a property, the bank won’t let you buy it through the LLC. If you buy it personally and then try to put it in the LLC, the bank can call your loan. A catch 22. Has anyone else run into this?

    • William Clark

      You may want to look into using a Land/Grantor’s Trust. Look up garn st. germain act. This is a federal act that was signed into being back during the Reagan administration. Besides deregulating financial institutions to allow for more homeownership (that’s overly simplified). Besides the deregulation, the Garn St. Germain Act also has a verbiage that allows anyone to place their real estate in their own trust withOUT triggering the due-on-sale clause. You can google out “Garn St Germain Act” and research for yourself. The act is named after Congressman Fernand St. Germain (Democrat from Rhode Island) and Senator Jake Garn, Republican from Utah.

    • Nick Baldo

      Hey Mike,

      Yes…this can be done and is quite common. Once you have an LLC established with a decent performance history, you can get commercial loans. These loans will typically be associated with one or more properties pledged as collateral.

      In our experience, these loans are actually a lot easier and more flexible than personal residential loans. However, they can also be more expensive.

      After purchasing our first two rental properties in our personal names, my business partner and I have used private/ commercial loans to our business for everything else.

      Let me me know if you have any specific questions.

  8. John Narez

    @ Mike Hanneman: Mike, I’m assuming your LLC has it’s own Federal ID number. If so, what might be a good idea is for you to have your LLC to develop it’s own credit rating prior to seeking a re-fi. It will then have a positive track record when it’s time to talk to any banker.

  9. Andrew Sharaf

    Hello Nick,
    could you please share some details of what these commercial lenders consider to be a decent performance history of an LLC, is length of time in business a high impact factor for being considered for such loans? Is personal credit score or profile etc even comes into play? or these commercial lenders strictly run on your Business credit and profile? if they do infact only consider business profile? what can i do to build that profile as a new llc?

    • Nick Baldo

      Hi Andrew…sorry for the delay!

      Length of time in business is a an important factor for commercial loans. The standard that lenders typically like to see if > 2 years of tax returns. Personal credit/ financials carries some weight, but not much. I’m not sure on the exact thresholds, but in general these lenders were just looking for “average” credit/ financials.

      The good thing about working with local/ regional banks is that you typically get to meet live with a loan officer. This gives you a chance to pitch yourself, your business and your project. The loan officer should be left with faith that you and your business know what you’re up to. Your past history, even if its just a couple years, shows that you are serious and that you can maintain a business through the starting stages.

      To be honest, lenders spent a lot less time vetting me/ my business and a lot more time vetting the actual deal. In addition, once you have a relationship with a lender, you can start additional entities to which they will lend. Its not like you need to wait another 2 years before you can get lending from a specific bank.

      I hope that helps…let me know if any other specific questions.

      • Edgar Gutierrez

        Hey Nick,

        I have been scrolling through these posts and have found your posts extremely helpful. Thank you for all of your insight. It is really helping me out as I have just started my LLC being taxed as an S Corp. The timing could not have been better as I am currently in the process of opening my business checking account with a local community bank.
        A million thanks!

        -Edgar G.

  10. Hi

    protrct yourself and form a separate entity, I get that.

    How does one go about buying a property to begin with thigh if the entity is new, it doesn’t have money for down payment or credit to get financing.

    I don’t think u can buy as an individual and then transfer ownership either can you? The mortgage would need to be transferred too, no?

    • I think he recommends that mostly for tax reasons. Regular income in an LLC has to be matched with self employment tax. Much of that tax burden can be avoided with an S corp. The exception for LLC income/self employment tax is real estate income.

    • John Laabs

      Just reading this for the first time, from the books I have read and some discussions, in the state of Minnesota (but I think even at the Federal level), you do not want to do real estate dealings in a C corp, I don’t recall the exact reasons but their are tax issues. Everything I have read it seems best to do a LLC (taxed as an S Corp) or do an S Corp. Since I have an S Corp for and an LLC, I will say from a setup and maintenance standpoint, the LLC (taxed as an S Corp) is much easier to maintain (avoiding the “piercing of the corp veil).

  11. I am not planning to do a 1031 exchange of my current property into a larger one. It will be the only property I own and I will have no partners. Does it make sense to set up a special entity to hold title to the property? Maybe I can protect myself by spending a little more on insurance.

  12. William Clark

    A lot of really good questions and responses. I think one, if not the reason, that a template for a business structure isn’t really given is because each individual has their own business goals. What works for one person (buy and hold) won’t work for someone else (wholesaler) from what I’ve read and researched. If I’m wrong, tell me.

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